Chapter 19: Problem 15

Use the aggregate expenditures-output model and assume an economy is in equilibrium at $\$ 5$ trillion, which is $\$ 250$ billion below fullemployment GDP. If the marginal propensity to consume $(M P C)$ is $0.60,$ full- employment GDP can be reached if government spending a. decreases by $\$ 60$ billion. b. decreases by $\$ 100$ billion. c. decreases by $\$ 250$ billion. d. is held constant.

Short Answer

Expert verified

None of the given options will result in an increase in GDP of \$250 billion to reach full employment GDP as required. An increase in government spending, not a decrease or maintaining the status quo, would push the economy towards full employment GDP.

Step by step solution

Calculate the spending multiplier

Given that MPC is 0.60, the spending multiplier can be calculated as $ \frac {1} {1 - 0.60} = 2.5 $. This implies that every dollar of new spending brings about a \$2.5 increase in income.

Determine the desired increase in GDP

The current GDP is \$5 trillion, which is \$250 billion below the full employment GDP. This means the economy needs to increase by \$250 billion to reach full employment GDP.

Choose the proper option

Now that we know the spending multiplier and the needed income increase, we can try out the changes proposed in the answer choices to see which would result in an increase in GDP of \$250 billion. a. If government spending decreases by \$60 billion, the change in GDP would be -\$60 billion * 2.5 = -\$150 billion. So, this contrast with the desired increase. b. If government spending decreases by \$100 billion, the change in GDP would be -\$100 billion * 2.5 = -\$250 billion. Again, this is opposite to what is stated in the exercise. c. If government spending decreases by \$250 billion, the change in GDP would be -\$250 billion * 2.5 = -\$625 billion, which is a reduction not an increase. d. If the government spending is held constant, the income level will remain the same, since there is no change in government spending. Therefore, none of the options listed allow for an increase in GDP of \$250 billion to reach the full employment GDP. What's required is an increase in autonomous spending, not a decrease or maintaining the status quo. An increase in government spending, rather than decrease, would push the economy towards the full employment GDP.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Marginal Propensity to Consume

When we talk about the Marginal Propensity to Consume (MPC), we refer to the ratio of the change in consumption resulting from a change in income. If the MPC is 0.60, this suggests that for every dollar gained, consumers will spend 60 cents and save the remaining 40 cents. Understanding the MPC is critical as it plays a pivotal role in determining the strength of the multiplier effect in an economy. It is also key to understanding how policies such as government spending can influence overall economic activity.

For instance, if an economy with a high MPC receives government stimulus, the impact of that spending is magnified throughout the economy, as households spend the majority of additional income. Conversely, in economies with a low MPC, a similar stimulus would have a reduced effect, as more of the additional income is saved rather than spent.

Full Employment GDP

Full employment GDP, also referred to as potential GDP, is the total value of goods and services that an economy can produce when it is operating at maximum sustainable employment levels without accelerating inflation. This concept does not mean zero unemployment, as there will always be a certain level of frictional and structural unemployment. The key takeaway here is that full employment GDP represents a target that governments aim for to ensure that the economy is using its resources efficiently.

When actual GDP falls below the full employment GDP, it indicates that the economy is not operating at its full potential and may need an injection of spending to stimulate growth and move closer to the full employment benchmark. Conversely, if the actual GDP exceeds this level, it could signal an overheated economy leading to inflationary pressures.

Spending Multiplier

The spending multiplier is a representation of how initial spending leads to increased total income in an economy. It is calculated as the reciprocal of 1 minus the MPC. In the exercise example, with an MPC of 0.60, the spending multiplier is 2.5. This multiplier effect indicates that an autonomous change in spending will result in a larger change in GDP. In other words, a dollar spent by the government can lead to a cumulative increase in income and consumption as it cycles through the economy.

Understanding this concept is crucial when determining the impact of fiscal policies. In the provided example, if the government wanted to increase the GDP to full employment levels, it could use the multiplier to gauge the required increase in government spending. However, it's important to note that the exact impact of the multiplier can be influenced by various factors such as the state of the economy and other fiscal policies in place.

Government Spending

Government spending is a component of fiscal policy and includes all government consumption, investment, and transfer payments. It is used as a tool to influence economic conditions. When an economy is not at full employment GDP, increasing government spending can lead to an increase in aggregate demand, thereby increasing production and possibly leading to higher employment levels.

However, it's not just about increasing spending; the type of government spending matters as well. Expenditures that have a direct impact on productive capacity, such as infrastructure or education, may have a more significant long-term benefit than other types of spending. In our scenario, since the goal is to achieve full employment GDP, thoughtfully increasing government spending could help to bridge the gap between the current and desired levels of output.

Economic Equilibrium

Economic equilibrium in the context of the aggregate expenditures-output model occurs when the total amount of goods and services produced (output) is equal to the total amount of goods and services demanded (aggregate expenditures). At this point, the economy is neither contracting nor expanding; it is stable. Adjustments in the economy, such as changes in government spending that were discussed in our problem, can shift this equilibrium.

If government spending changes without causing a positive or negative demand shock, the economy remains in equilibrium, albeit at a potentially different level of output. In the situation outlined in our exercise, to reach full employment GDP and thus a new, higher equilibrium, the economy needed an increase in spending—particularly an increase in government spending—as the private sector alone was not reaching the full employment output level.