Question

1) Suppose that the national economy is experiencing a recession with an estimated recessionary gap of $10 billion. Congress is considering the use of fiscal policy to ease the recession, and due to current political sentiments, it has determined that the maximum spending increase the government is willing to support is $3 billion. The government wants to make up the remainder of the recessionary gap using tax cuts. If a spending increase of $3 billion is approved and the MPC is 0.6, by how much will taxes need to be reduced to close the remainder of the recessionary gap?

____ Billion?

Assume that a hypothetical economy with an MPC of 0.8 is experiencing severe recession.

2) By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion?

3) How large a tax cut would be needed to achieve the same increase in aggregate demand?

Round your answer to 2 decimal places and enter your answer as a positive number.

4)Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

Increase govnt spending by____

Increase taxes by______

5) Economists nearly uniformly support an independent Fed rather than one beholden directly to either the president or Congress because

A) this will ensure lower interest rates.

B) this independence allows the Fed to more effectively control the money supply and maintain price stability.

C) economists don’t trust the president or Congress.

D) special interests are changing too frequently.

Answer 1

1) Goverment spending Multiplier=1/(1-Mpc)=1/(1-0.6)=1/0.4=2.5

So Increase in spending by 3 billion will increase GDP=∆G*Multiplier=3*2.5=7.5

Now the additional Increase in income required to reach full employment level GDP=10-7.5=2.5

Tax multiplier=-mpc/(1-mpc)=-0.6/(1-0.6)=-0.6/0.4=-3/2=-1.5

So Increase income by 2.5 billion, required tax cut=2.5/1.5=1.67 billion

2) required Increase in AD=25 billion

Multiplier=1/(1-mpc)=1/(1-0.8)=1/0.2=5

So required Increase in government spending=25/5=5 billion

3)Tax multiplier=-mpc/(1-mpc)=-0.8/(0.2)=-4

Required Increase in AD=25 billion.

Required tax cut=25/4=6.25 billion

4) outstanding debt remain constant ,means Increase in spending will funded by Increase in tax,so it is balance budget Increase.

Balance budget multiplier=goverment spending multiplier+ tax multiplier=1/(1-mpc)+(-mpc)/(1-mpc)=(1-mpc)/(1-mpc)=1

Balance budget Multiplier=1

So to increase AD by 25 billion both goverment spending and tax should increase by 25 billion.

5) option B is correct