Assume the economy has a GDP of $11,500 billion. The unemployment rate is at 7.3

Question

Assume the economy has a GDP of $11,500 billion. The unemployment rate is at 7.3% and has been slowly rising for the last 6 months. Inflation was at 2.3% one year ago but has since dropped to near 0%. The MPC in the economy is .80 and the Natural Rate of Unemployment is 4.5%. The target rate for inflation is 2%.

a. What problem is the economy currently facing?

b. Is the problem serious enough that government should act to solve it?

c. If the government does decide to act, what size government expenditure would fix the problem

d. What size tax change would fix the problem?

e. Why would it be better for government to solve the problem using government purchases (part c above) rather than taxes (part d above) to solve the problem? f. Assuming that government does decide to use the tax policy, what could happen to cause the policy to be ineffective?

Explanation / Answer

a. What problem is the economy currently facing?

Economy is facing problem of recession, economy is operating below its potential level. Aggregate demand is deficient here.

b. Is the problem serious enough that government should act to solve it?

Yes, this is very serious problem. Unemployment is rising and inflation is falling down. Government must act here immediately to reverse this trend.

c. If the government does decide to act, what size government expenditure would fix the problem

according to Okun’s law, 2 % rise in GDP will increase 1 % employment. Short fall in employment 7.3 – 4.5 = 2.8 %

there must be 5.6 % rise in GDP to eliminate unemployment.

Increase in GDP required = 5.6 % of 11500

                                               = 644 Billion

Multiplier Value = 1/1-0.8

                     = 5

Change in government expenditure required * 5 = 644

Change in expenditure = 128.8 Billion

d. What size tax change would fix the problem?

Tax multiplier = 4

Change in Tax *4 = 644

Change in tax = 644/4

         = $ 161 Billion

e. Why would it be better for government to solve the problem using government purchases (part c above) rather than taxes (part d above) to solve the problem?

Government expenditure multiplier is larger than tax multiplier. Hence, it is better option to go with government expenditure plan.

f. Assuming that government does decide to use the tax policy, what could happen to cause the policy to be ineffective?

It may reduce their demand and increase saving to avoid future uncertainties. It will make tax policy quite ineffective.

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