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24 September, 22:58

Assuming that the MPC =.75 and that prices are constant, which of the following fiscal policies would eliminate a recessionary gap of $60 billion while maintaining a balanced budget?

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  1. 25 September, 00:45
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    Increasing government spending by $60 billion while raising taxes $60 billion

    Explanation:

    If we do the multiplicator of Government spending which is equal to = 1/MPS

    And MPS (marginal propensity to save) = 1 - MPC (marginal propensity to consume)

    But MPC = 0.75

    Hence multiplicator of Government spending = 1 / (1-0.75) = 4

    If we look for the multiplicator of taxes = - MPC/MPS

    But MPS = 1 - MPC

    = - MPC / (1-MPC)

    = - 0.75/0.25 = - 3

    Hence if government spending is increased by $60 billion, GDP will be increased by 60 x 4 = $240 billion

    Also if taxes are increased by the same amount, GDP will decrease by 60x3 = $180 billion

    Hence this means that GDP will increase by 60 billion dollars, as the difference between the both is 240 - 180 = 60 billion dollars
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