Attempts: 0.5 Keep the Highest: 0.5/1 8. Problems and Applications Q8 An economy

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Attempts: 0.5 Keep the Highest: 0.5/1 8. Problems and Applications Q8 An economy is operating with output $300 billion below its natural level, and fiscal policymakers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run To close the recessionary gap, the government would need to spending be billion. Grade It Now Save & Continue

Explanation / Answer

Multiplier = 1 / (1 - MPC) = 1 / [1 - (4/5)] = 1 / (1/5) = 5

It means that if government increases spending by $1, output increases by $5. Therefore,

To close the recessionary gap (to increase output by $300 billion), government would need to increase spending by $60 billion (= $300 billion / 5).

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