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Chapter 27: Problem 6

Suppose that real GDP is currently \(\$ 17.1\) trillion, potential GDP is \(\$ 17.4\) trillion, the government purchases multiplier is \(2,\) and the tax multiplier is -1.6 . a. Holding other factors constant, by how much will government purchases need to be increased to bring the economy to equilibrium at potential GDP? b. Holding other factors constant, by how much will taxes have to be cut to bring the economy to equilibrium at potential GDP? c. Construct an example of a combination of increased government spending and tax cuts that will bring the economy to equilibrium at potential GDP.

Short Answer

Expert verified
To bring the economy back to equilibrium: a) The government would need to increase purchases by \$0.15 trillion. b) Taxes would need to be cut by \$0.1875 trillion. c) A combination solution might be an increase in government spending of \$0.075 trillion with a cut in taxes of \$0.09375 trillion.

Step by step solution

01

- Calculate GDP Gap

The GDP gap can be calculated as the difference between potential GDP and real GDP. Calculate the GDP gap: \(GDP Gap = Potential GDP - Real GDP = 17.4 trillion - 17.1 trillion = \$0.3 trillion.\)
02

- Determine Government Purchase Increase

The increase in government purchases can be calculated by dividing the GDP gap by the government purchases multiplier. Thus, \(Increase in Government Purchases = GDP Gap / Government Purchases Multiplier = \$0.3 trillion / 2 = \$0.15 trillion.\)
03

- Calculate Tax Cut Needed

The reduction in taxes required can be calculated by dividing the GDP gap by the negative of the tax multiplier. Thus, \(Tax Cut = GDP Gap / -Tax Multiplier = \$0.3 trillion / - (-1.6) = \$0.1875 trillion.\)
04

- Determine Combination of Government Purchase Increase and Tax Cut

This example could include varying combinations of the increase in government spending and decrease in taxes that would sum up to the required GDP increase. One such instance could be a half proportion of the solutions calculated in Step 2 and Step 3: An increase in government spending of \$0.075 trillion with a tax cut of \$0.09375 trillion. Note, the effects and hence their respective changes in spending and cuts should add up to \$0.3 trillion (the GDP gap) to bring economy to potential GDP.

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Most popular questions from this chapter

(Related to Solved Problem 27.6 on page 971 ) A 2015 article in the Wall Street Journal noted that an official of the European Union was forecasting that "Greece faces two years of recession amid sharp budget cuts." What typically happens to a government's budget deficit during a recession? Do governments typically respond with budget cuts as the Greek government did? Briefly explain.

Write the equation that links real GDP growth to its two determinants. Briefly explain why the relationship indicated by the equation holds.

Use an aggregate demand and aggregate supply graph to illustrate the situation where equilibrium initially occurs with real GDP equal to potential GDP and then the aggregate demand curve shifts to the left. What actions can Congress and the president take to move real GDP back to potential GDP? Show the results of these actions on your graph. Assume that the long-run aggregate supply (LRAS) curve doesn't shift.

What is the tax wedge?

In a column in the Financial Times, the prime minister and the finance minister of the Netherlands argued that the European Union, an organization of 28 countries in Europe, should appoint "a commissioner for budgetary discipline." They said that "the new commissioner should be given clear powers to set requirements for the budgetary policy of countries that run excessive deficits." What is an "excessive" budget deficit? Does judging whether a deficit is excessive depend in part on whether the country is in a recession? How can budgetary policies be used to reduce a budget deficit?
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