Question

macroeconomics

Fiscal Policy In Class Assignment You are hired by the president who believes that the economy is operating at a level of $3.2 trillion and that the potential output is $3 trillion. You are told that the national marginal propensity to consume (MPC) is 0.8. What type of government intervention might you recommend, if any? Discuss how this fiscal policy can be implemented through a change in government spending (how much should government spending change). Show your answer graphically using the AS / AD model. 2. In general, demand-side fiscal policy focuses on incentives to increase spending and shift the AD, and supply-side fiscal policy focuses on incentives to increase production and shift the LRAS. For each fiscal policy listed below, determine if it is demand-side or supply -side or both. Explain your reasoning. a) A $1,000-per-person tax rebate b) Government-sponsored prizes for new scientific discoveries c) Increasing unemployment compensation d) Government funded 2-year college grants to all U.S. citizens

Answer 1

Answer)

First, we find the fiscal spending multiplier which is calculated as follows:

Spending multiplier = 1 / (1 - MPC)

= 1/(1 - 0.8)

Multiplier = 5

Total change in income = (Multiplier) × (Change in spending) .....eq(2)

As the actual output = $3.2 trillion and potential output = $3 trillion. So, the output must be decreased by $0.2 trillion (i.e. $200,000,000,000)

Substituting the above values in the spending multiplier gives,

200,000,000,000 = 5 × (change in income)

Change in income = (200,000,000,000)/5 = > $40,000,000,000

So, the spending of the government must decrease by $40 billion.

This refers to the case of contractionary fiscal policy.

As we can see in the below diagram that when the government reduces its spending, the AD curve shifts leftward and there is a decline in the output in the economy.

AD Price AS AD1 AD AD1 AS 3 3.2 Output($, trillion