Question

A country is in the midst of a recession with real GDP estimated to be $4.5 billion below potential GDP. The government's policy analysts believe the current value of the marginal propensity to consume (MPC) is 0.90 Instructions: Enter numbers rounded to two decimal places. f the government wants real GDP to equal potential GDP, it should increase government spending by $billion. Alternatively it could reduce taxes by S billion. b. Suppose that during the recession, people have become less confident and decide they will only spend 50% of any additional income. In this case, if the government increases spending by the amount calculated in part a, real GDP will end up (Click to select) potential GDP by Sbillion C. With the same decrease in consumer spending described in part b, if the government decreases taxes by the amount calculated in part a, then real GDP will end up (Click to select)potential GDP by $ billion. d. Given your answers above, what can we conclude? When the government changes spending or taxes, it is easy to predict the exact impact on real GDP. If the government overestimates the value of the MPC, then its change in spending or taxes will be too large and real GDP will exceed potential GDP If the government overestimates the value of the MPC, then its change in spending or taxes will be too small and real GDP will fall short of potential GDP OIt is easy for the government to predict the value of the MPC prior to any changes in spending or taxes.

Answer 1

Answer:

a. The government needs to increase spending by $0.45 billion and decrease taxes by $0.5 billion.

b. The real GDP will fall short of potential GDP by $3.6 billion.

c. The real GDP will fall short of potential GDP by $4 billion.

d. If government overestimates MPC change in spending or taxes will be too small.

Explanation:

The GDP gap is $4.5 billion.

a. The marginal propensity to consume is 0.90.

Government spending multiplier

= $\frac{1}{1-MPC}$

=  $\frac{1}{1-0.9}$

= 10

The government needs to increase spending by

= $\frac{GDP\ Gap}{Government\ spending\ multiplier}$

= $\frac{4.5}{10}$

= $0.45 billion

Tax multiplier

= $\frac{-MPC}{1-MPC}$

= $\frac{-0.9}{1-0.9}$

= -9

The government needs to decrease taxes

= $\frac{GDP\ Gap}{Tax\ multiplier}$

= $\frac{4.5}{9}$

= $0.5 billion

b. The marginal propensity to consume is 0.50.

Government spending multiplier

= $\frac{1}{1-MPC}$

=  $\frac{1}{1-0.5}$

= 2

If the government  increases spending by $0.45 billion,

The real GDP will increase by

= $Increase\ in\ spending\ \times\ Spending\ multiplier$

= $\ 0.45\ \times\ 2$

= $0.9 billion

The real GDP will fall short of potential GDP by

= $4.5 billion - $0.9 billion

= $3.6 billion

c. Tax multiplier

= $\frac{-MPC}{1-MPC}$

= $\frac{-0.5}{1-0.5}$

= -1

If the government decreases taxes by $0.5 billion

The real GDP will increase by

= $0.5\ billion\ \times 1$

= $0.5 billion

The real GDP will fall short of potential GDP by

= $4.5 billion - $0.5 billion

= $4 billion

d. If the government overestimates the value of the MPC, then its change in spending or taxes will be too small and real GDP will fall short of potential GDP.