Question

Suppose as the chief economic advisor, the minister of finance calls you to his office and says the following

" Unemployment is too high, we need to lower it by increasing both output and income. Right now the equilibrium level of income /output is $900 billion dollars, but perhaps an acceptable unemployment rate could be achieved if aggregate output increase to $1100. billion. Note however that the MPC is .75 and taxes must remain at the present level. So adjusting taxes is out of the question"

1. Under the circumstances outlined above, explain how the government can use fiscal policy ie taxation and spending, to increase the equilibrium level of output from 900billion to 1100 billion

11. using a 45degrees line diagram graph the original situation and solution you gave in (1) above

Answer 1

Question a)

Since the government spending multiplier is

1/(1-MPC) = 1/.25 = 4

Thus to increase output by 200, increase government spending by $50.

Since we can't adjust the taxes, so only source of fiscal expansion is to increase G

As multiplier = ∆Y/∆G

So ∆G = ∆Y / multiplier = 200/4= 50$ Answer

answer b)