Chapter 11: Problem 46

If there is a recessionary gap of $\$ 100$ billion, should the government increase spending by $\$ 100$ billion to close the gap? Why? Why not?

Short Answer

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In short, increasing government spending by $100 billion could help close the recessionary gap of the same amount due to the multiplier effect, which stimulates job creation and economic growth. However, this approach may also lead to inflation and higher national debt. Therefore, it's crucial to consider the specific economic conditions and potential consequences before making a decision.

Step by step solution

Understand the Recessionary Gap

A recessionary gap occurs when the Real GDP (Gross Domestic Product) is less than the potential GDP (real GDP at full employment), indicating that an economy is underperforming and has a high unemployment rate. In this case, the recessionary gap is given as $100 billion, which means that the economy is operating below its potential by this amount.

Role of Government Spending

When the government increases its spending, it injects more money into the economy, leading to job creation and increased consumer spending. This could help to increase the real GDP and move the economy closer to its potential GDP or full employment. It is important to note that this is a Keynesian economics approach called fiscal policy, which suggests that the government can influence the economy through its spending decisions.

The Multiplier Effect

One of the reasons why an increase in government spending might close the recessionary gap is the multiplier effect. The multiplier effect refers to the increased economic impact that results from the initial increase in government spending. For example, if the government spends more on infrastructure projects, it creates jobs which in turn increases consumer spending, leading to further job creation and economic growth. This ripple effect could help close the recessionary gap beyond the initial government spending increase.

Consider Potential Drawbacks

Increasing government spending is not without its drawbacks. For one, it could lead to higher inflation, as more money in the economy may cause prices to rise. In addition, increased government spending could lead to higher budget deficits and potentially increased national debt. This may not be sustainable in the long term.

Conclusion

In conclusion, whether the government should increase its spending by $100 billion to close the recessionary gap depends on the current economic situation and the potential consequences. Increasing government spending can indeed help close the gap through the multiplier effect, but it could also lead to inflation and higher national debt. It is essential to weigh these factors and take into account the specific conditions of the economy before making a decision.