Question

The economy of Newland is in short-run macroeconomic equilibrium. The current real output is $400 billion, and the full employment output is $500 billion. The marginal propensity to consume is 0.8.

(a) Is the economy experiencing a recessionary output gap or an inflationary output gap? Explain.

(b) Assume Newland’s government is considering taking action to close the output gap identified in part (a).

(i) Calculate the minimum change and indicate the direction of change in government spending required to shift the aggregate demand curve to close the output gap. Show your work.

(ii) If instead Newland’s government changes taxes without changing government spending, calculate the minimum change and indicate the direction of change in taxes required to shift the aggregate demand curve to close the output gap. Show your work.

(c) Which fiscal policy action, changing government spending or changing taxes, is more effective in closing the output gap? Explain.

(d) Assume instead Newland’s government decides not to take any policy action. Will short-run aggregate supply increase, decrease, or stay the same in the long run? Explain.

Please respond on separate paper, following directions from your teacher.

Answer 1

Answer:

Please find attached solution.

Explanation:

Answer 2

The economy is experiencing a recessionary output gap.

• a. The economy is experiencing a recessionary gap. A recessionary gap occurs when the potential GDP is more than the Real GDP. In this case, the current output is less than the full employment level of output.

• b i. If Newland’s government is considering taking action to close the output gap, the there'll be an increase in the government expenditure by $20 billion. This is calculated thus:

Government spending multiplier will be:

= 1/(1 - MPC) = 1/(1 - 0.8) = 1/0.2 = 5

Gap to be closed = 500 - 400 = 100

Increase in government expenditure that's required = 100/5 = $20 billion

• b ii. The minimum change in taxes required to shift the aggregate demand curve to close the output gap will be calculated thus:

Tax multiplier = MPC/(1 - MPC) = 0.8/(1 - 0.8) = 4

Decrease in tax that's required will be:

= Gap to be closed / Tax multiplier

= (500 - 400) / 4

= 100/4

= $25 billion

There'll be a reduction in tax by $25 billion

• c. It should be noted that increasing the government spending will be more effective in closing the output gap.

• d. If Newland’s government decides not to take any policy action, the short-run aggregate supply increase in the long run. This will lead to a shift to the right.

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