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Chapter 13: Q. 11 (page 297)

Currently, a government's budget is balanced. The marginal propensity to consume is \(0.80. The government has determined that each additional \)10 billion it borrows to finance a budget deficit pushes up the market interest rate by role="math" localid="1651613391961" 0.1 percentage point. It has also determined that every role="math" localid="1651613378175" 0.1-percentage point change in the market interest rate generates a change in planned investment expenditures equal to \(2 billion. Finally, the government knows that to close a recessionary gap and take into account the resulting change in the price level, it must generate a net rightward shift in the aggregate demand curve equal to \)200 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase its expenditures? (Hint: How much private investment spending will each $10 billion increase in government spending crowd out?)

Short Answer

Expert verified

As a result, the government will have to boost its spending by $50 billion to meet its goal.

Step by step solution

01

Introduction 

The given is the current balanced budget of the government

The objective is to determine how much should the government increase its expenditure

02

Explanation 

The proportionate change in consumption due to a proportionate change in income is referred to as marginal propensity to consume (MPC).

03

Calculation 

We must first obtain the multiplier. Calculate the multiplier as follows:

Given: MPC is 0.80.

Then

Multiplier =11-MPC

=11-0.80=10.2=5

In order to shift the aggregate demand curve rightward by $200 billion, total autonomous spending must be increased by $40 billion ($200÷5).

As a result, if the government spends an additional $50 billion, the market interest rate rises by 0.5 percent, lowering the anticipated investment by $10 billion. This amounts in a net increase of $40 billion in overall autonomous spending.

As a result, the government will have to boost its spending by $50 billion to meet its goal.

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Most popular questions from this chapter

In May and June of 2008, the federal government issued one-time tax rebates - checks returning a small portion of taxes previously paid to millions of U.S residents, and U.S. real disposable income temporarily jumped by nearly $500 billion. Household real consumption spending did not increase in response to the short-lived increase in real disposable income. Explain how the logic of the permanent income hypothesis might help to account for this apparent non relationship between real consumption and real disposable income in the late spring of 2008.

Determine whether each of the following is an example of an automatic fiscal stabilizer.

a. A federal agency must extend loans to businesses whenever an economic downturn begins.

b. As the economy heats up, the resulting increase in equilibrium real GDP per year immediately results in higher income tax payments, which dampen consumption spending somewhat.

c. As the economy starts to recover from a severe recession and more people go back to work, government-funded unemployment compensation payments begin to decline.

d. To stem an overheated economy, the president, using special powers granted by Congress, authorizes emergency impoundment of funds that Congress had previously authorized for spending on govemment programs.

Recall that the Keynesian spending multiplier equals 1 /(1-MPC). Suppose that in panel (b) of Figure 13-1, the government knows that the MPC is equal to 0.75 and that the amount of the horizontal distance that the AD curve had to be shifted directly leftward from point E1 was equal to $1.0 trillion. What is the reduction in real government spending required to have generated this shift?

Assume that the Ricardian equivalence theorem is not relevant. Explain why an income-tax-rate cut should affect short-run equilibrium real GDP.

Every 1-percentage-point increase in the marginal income tax rate induces some workers to supply less labour, which cuts real GDP by \( 0.2 trillion. At the same time, each 1-percentage point increase in the marginal income tax rate causes spendable income to drop, which induces some workers to supply labour that yields \) 0.1 trillion more in real GDP. Is the net outcome consistent with the supply-side theory? Why?
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