Question

Suppose the economy is operating at an output level of $5,400 billion. Assume furthermore that potential output is $5,000. Which would be necessary to close this inflationary gap if the marginal propensity to consume is 0.75?

Answer 1

Answer:

The government should decrease spending by $100 billion.

Explanation:

The potential output level of an economy is $5,000 billion.  

The economy is operating at an output level of $5,400 billion.  

We see that there is an inflationary gap of $400 billion as the economy is operating at an output level of $400 billion more than the potential output level.  

The marginal propensity to consume is 0.75.  

ΔY = $\frac{1}{1 - MPC}\ \times\ \Delta G$

$400 billion = $\frac{1}{1 - 0.75}\ \times\ \Delta G$

ΔG = $\frac{400}{4}$

ΔG = $100 billion