Question

An economy is operating with output $200 billion above its natural level, and fiscal policymakers want to close this expansionary 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 expansionary gap, the government would need to decrease or increase spending by ? billion.

Answer 1

Answer and Explanation:

In order to close the inflationary gap, the government should have to reduce the spending

The multiplier is

= 1 ÷ MPS

= 1 ÷ (1 ÷ 5)

= 5

Now the government spending would be reduced by

= $200 billion ÷ 5

= $40 billion