Question

If short-run equilibrium output equals 10,000, the income-expenditure multiplier equals 10, and potential output (Y*) equals 9,000, then government purchases must ______ to eliminate any output gap.
A. increase by 100
B. decrease by 100
C. increase by 1,000
D. decrease by 1,000

Answer 1

Answer: Option (b) is correct.

Explanation:

Given that,

short-run equilibrium output = 10,000

income-expenditure multiplier = 10

potential output (Y*) = 9,000

Expenditure multiplier = $\frac{1}{1-slope\ of AE function}$

10 = $\frac{1}{1-slope\ of AE function}$

Slope of AE function = 0.9

slope of AE =  MPC (1-t)  t =0,

MPC = 0.9

Delta Y (DY) = 1000

government expenditure multiplier ⇒ $\frac{1}{1 - MPC}$ = 10

Delta G = $\frac{DY}{government\ expenditure\ multiplier}$

             = $\frac{1,000}{10}$

             = 100

Government purchases must be Decrease by 100.