Question

1. Suppose that the marginal propensity to consume in a country is 0.8, and the real potential output and current real GDP are respectively $800 billion and $700. To bring the economy to potential output, the government should increase its expenditure by $100 billion.

   True

   False

Answer 1

Here the current real GDP falls below the potential output and that is a recessionary gap, to close the recessionary gap the government should use an expansionary fiscal policy that is either a decrease in the taxes or an increase in the government spending. In the given context the recessionary gap is about 100 billion (800-700) and the government does not necessiarly increase the spending by 100 billion or decrease taxes. In the economy there is multiplier effect , that is an initial increase in the income leads to a more than proportional increase in the final income and it is depended on the marginal propensity to consume.

Multiplier .

= 1/1 - MPC

  .

= 1/1-80

  .

=11.2

  $=5$.

Here the multiplier is 5 so the government need to increase the spending by 20 billion. .

(5 x 20 = 100)

Ans: FALSE.