brownwood9674 brownwood9674

09-12-2022
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Assume a simple closed Keynesian model where the MPC is 0.9 and the MPIM is 0.1. Also assume that potential real GDP is $1000 million, while actual (equilibrium) real GDP is $800 million.
a. What is the GDP gap?
b. Is there an inflationary or recessionary gap?
c. What change in government spending is required to restore the economy to full employment GDP? Show graphically using a Keynesian cross diagram.
d. What change in lump-sum taxes would bring about the same result?
e. Now assume that a Balanced Budget Amendment is passed, so that increases in government spending must be accompanied by equal increases in lump-sum taxes. What change in both G and T will close the GDP gap? (HINT: What is the balanced budget multiplier in this model?)
f. Of the changes in c), d) and e), which causes the largest increase in the deficit? Why?

Answer :

PallaviB PallaviB

16-12-2022

a. The GDP gap is $200 million.

b. There is a recessionary gap.

c. The change in government spending required to restore the economy to full employment GDP is $200 million. This can be seen graphically in the Keynesian cross diagram below.

d. The change in lump-sum taxes required to restore the economy to full employment GDP is also $200 million.

e. The change in both G and T required to close the GDP gap is an increase in both government spending and lump-sum taxes of $133.3 million each. This is because the balanced budget multiplier in this model is 0.67 (MPC/(1-MPC)).

f. The change in c) causes the largest increase in the deficit because it requires an increase in government spending of $200 million with no change in taxes.

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