3. In Country X, GDP is $400B below the full-employment level of output. Governm

Question

3. In Country X, GDP is $400B below the full-employment level of output. Government officials have measured the marginal propensity to consume at 0.75.

A. The government wants to use fiscal policy to bring the economy back to full employment.

I. If the government wants to achieve this through a change in spending, what change would be necessary? (8 points)

II. If the government wants to achieve this through a change in taxes, what change would be necessary? (8 points)

III. If the government wants to achieve this without creating a budget deficit, what change would be necessary? (8 points)

B. Say that for a variety of reasons, the government shows that it is not up to the task of conducting fiscal policy. The central bank steps up and does something about it. If a 1% decrease in interest rates leads to an increase in investment of $50B, how should the central bank's interest rate targets change? (13 points)

Explanation / Answer

Ai) If the government wants to achieve full employment through a change in spending , it needs to increase spending. In the GDP identity, GDP= C+I+G +x-M . Here , an increase in G ( government spending) will directly increase the GDP of the country. Government spending can be in infrastructure, such as roads, bridges and also in education etc ..This stimulates the economy and tends to increase jobs and private investment . thus increase in G indirectly increases consumption and positively impacts investment .

ii) A reduction in taxes can also increase GDP . As taxes are reduced , consumers have more money in their hands to spent . Thus consumption rises. Reduction in corporate taxes also will help companies divert money into investment needed to increase output required to meet the increased demand generated through tax cuts . Thus C rises and I rises so GDP rises . Employment also rises.

iii) If the government wants to achieve this without a change in budget deficit , it needs to mobilize other sources of revenue. For example, disinvestment of public companies can help to generate additional revenues that can be diverted to government spending in developmental activities. Also , the government can encourage foreign private investment as well as domestic private investments through relaxation of rules and regulations . This will also help increase in GDP.

B If a 1% decrease in interest rate increases investment by $50B. The Central bank should revise its interest rate target by 8% to achieve the full employment level GDP of $400 B

Related Questions

Navigate

• Browse (All)
• Browse 3
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.