Question

1. Explain the effects of the following actions on equilibrium income, assuming that the marginal propensity to consume is 0.7 a. Government purchases rise by $60 billion. b. Taxes fall by $60 billion.

2. Explain how fiscal policy can be used to close the (a) contractionary gap and (b) inflationary gap.

Answer 1

1) given that the marginal propensity to consume is 0.7. this implies that government spending multiplier is 1/(1-mpc) = 3.33 and tax multiplier is -mpc/(1-mpc) = -2.33.

When government purchases are increased by 60 billion , income will increase by 60*3.33 = 200 billion.

When taxes are reduced by 60 billion, income will increase by -60*-2.33 = 140 billion.

2) in case of contractionary gap, real GDP is less than its full employment level. Government increases its spending or reduces taxes in order to boost aggregate demand and increase real GDP to eliminate the gap. In case of inflationary gap, real GDP is more than its full employment. Government decreases its spending or increases taxes in order to discourage aggregate demand and decrease real GDP to eliminate the gap.