Question

1. Suppose in a simple closed economy with MPC = 0.75, the planned investment spending nas suddenly fallen, reducing AD and output to a level that below the natural level of output by 100 Million. Assume that the real interest rate is constant so that there is no crowding out of (gross) investment. (a) If the government decided to try to get the output back to the natural level of output using only a change in government spending (AG), by how much would G need to be increased? (b) If the government, instead of using (AG) from the previous question, decided to try to get the output back to the natural level of output using only a change in lump-sum tax (AT), how big of a change in tax would be needed? (c) Which fiscal policy, AG or AT, would create less amount of the government budget deficit? 2. Suppose Balticland is in long-run macroeconomic equilibrium before each of the following shock on aggregate demand occurs. Please identify which type of gap, inflationary or recessionary, will Balticland face after the shock, and what type of fiscal policies would help move Balticland back to potential output? How would your recommended fiscal policy shift the aggregate demand curve?

Answer 1

1) when mpc=0.75 then multiplier=1/1-Mpc=1/1-0.75=4

In order to increase output by 100 million, Government expenditure will increase by 25 million

b)tax multiplier= -Mpc/1-Mpc=-0.75/1-0.75=-3

Government should reduce taxes by 100/3=33.33 million in order to increase output by 100 million

c) Change in G will lead to less budget deficit for the government in order to increase same output