Question

QUESTION 4 With an upward-sloping aggregate supply curve, real output can be increased to the full employment output level if: O A Government expenditures are increased by the amount of the GDP gap. O B. Government expenditures are increased by the amount of the AD shortfall. C. Aggregate demand is increased by the amount of the GDP gap. o D. Govenment expenditures are increased by the amount of the AD shortfall divided by the multiplier QUESTION 5 To eliminate an AD shortfall of 100 billion when the economy has an MPS of 0 10 and MPI of 0.10, the govemment should increase transfer payments by- O A. $25 billion. B. $100 billion C. SSO billion .D. $20 billion

Answer 1

Solution:

Q4) When we are on the upward sloping part of aggregate supply curve, and real output falls short of full-employment output level, one way to achieve full-employment output level is by increasing the aggregate demand (shifting the aggregate demand curve outwards or to the right changes the equilibrium, increasing real output and price level in case of upward sloping AS curve). Important thing to note is that to cover the real output or GDP gap, AD needs to be increased by an amount more than the GDP gap, due to the upward sloping AS. Notice the graph below for the same: A is current GDP level, B is full-employment GDP level, GDP gap = B - A

Price Long run AS curve 1 Short run AS AD curve cuve GDP gap lncrease inD needed-to cover this gap A. Real output/GDP

Thus, your answer is incorrect. Now, government spending has a multiplier effect, in the sense it amplifies the aggregate demand. So, if govt. spending increased by AD shortfall, actual AD will be very high, and real output reached will be higher than full-employment level. So, in order to incorporate for the multiplier while increasing govt. spending, to bring the desirable amount of increase in AD (exact AD shortfall), govt spending must be increased by AD shortfall divided by multiplier, increasing the real GDP by a lower and desirable amount.

So, correct option is (D).

Q5) AD shortfall = $100 billion. So, AD needs to be increased by $100 billion

MPS = 0.10

MPC = 1 - MPS = 1 - 0.10 = 0.90

MPI = 0.10

Multiplier = 1/(1 - MPC + MPI) = 1/(1 - 0.90 + 0.10) = 1/0.2 = 5

Also, we know that change in AD = multiplier*change in transfer payments

Since, we want change in AD = +$100b, this becomes

$100b = 5*change in transfer payments

Change in transfer payments = $100b/5 = +$20b

Thus, government should increase transfer payments by $20b. Correct option is (D). (your answer is correct)

NOTE: Try to relate Q4 with Q5 to get even better understanding of the explanation provided in Q4.