Suppose the economy has a recessionary gap of $1,000B caused by a demand shock with unemployment...
Suppose the economy has a recessionary gap of $1,000B caused by a demand shock with unemployment is rising. You also know that the marginal propensity to consume is 0.75. Using the aggregate demand-aggregate supply model:
- Draw a picture depicting the situation. (10 points)
- Compute the multiplier. (10 points) (Show your work)
- Would you use contractionary or expansionary fiscal policy? How much would you need to change government spending? (10 points) (Show your work)
Homework Answers
A.
B.
Multiplier = 1/(1-MPC) = 1/(1-.75) = 4
C.
In this case, expansionary fiscal policy will be used.
size of the increase in government spending = 1000/4
size of the increase in government spending = $250 Billion
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