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Chapter 13: Q. 10 (page 297)

Consider the accompanying diagram, in which the current short-run equilibrium is at point A, and answer the questions that follow:

a. What type of gap exists at point A?

b. If the marginal propensity to consume equals 0.75, what change in government spending financed by borrowing from the private sector could eliminate the gap identified in part (a)? Explain.

Short Answer

Expert verified

a) The type of gap exists at the point is determined as inflationary gap

b) The changes in government spending reduced is found as$0.20trillion

Step by step solution

01

Introduction 

The given is the current short equilibrium at a point

The objective is to determine the type of gap and the changes in the expenses of the government

02

Explanation (part a)

a)

Since the current equilibrium at A, where real GDP is $18.8trillion and potential GDP is $18 trillion, This suggests that there is an inflationary gap.

03

Explanation (part b)

b)

The $0.8trillion budget deficit must be closed by reducing government spending. The multiplier is four times the value of MPS ($0.25).

As a result, a $0.20 trillion cut in spending is required.

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Most popular questions from this chapter

Consider the diagram below, in which the current short-run equilibrium is at point A, and answer the questions that follow.

a. What type of gap exists at point A?

b. If the marginal propensity to save equals 0.02, what change in government spending financed by borrowing from the private sector could eliminate the gap identified in part (a)? Explain.

Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policies.

A government is currently operating with an annual budget deficit of \(40 billion. The government has determined that every \)10 billion reduction in the amount it borrows each year would reduce the market interest rate by 0.1 percentage point. Furthermore, it has determined that every 0.1-percentage-point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to \(5 billion. The marginal propensity to consume is 0.75. Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price level, it must generate a net leftward shift in the aggregate demand curve equal to \)40 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? (Hint: How much new private investment spending is induced by each $10 billion decrease in government spending? )

Assume that MPC= 45when answering the following questions.

a. If government expenditures rise by \( 2 billion, by how much will the aggregate expenditure curve shift upward? By how much will equilibrium real GDP per year change?

b. If taxes increase by \) 2 billion, by how much will the aggregate expenditure curve shift downward? By how much will equilibrium real GDP per year change?

Suppose that Congress enacts a lump-sum tax cut of $750 billion. The marginal propensity to consume is equal to 0.75. Assuming that Ricardian equivalence holds true, what is the effect on equilibrium real GDP? On saving?
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