Question

An economy is operating with output $400 billion below its natural rate, and fiscal policymakers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run.

a. In what direction and by how much would government spending need to change to close the recessionary gap? Explain your thinking.
b. In what direction and by how much would taxes need to change to close the gap? Explain.
c. If the central bank were to hold the money supply, rather than the interest rate, constant in response to the change in fiscal policy, would your answers to the previous questions be larger, smaller, or the same? Explain.
d. If policymakers in this economy wanted to close the recessionary gap without increasing the government’s budget deficit, what are two ways they can accomplish this goal?

Answer 1

a. increase spending by borrowing the money from the central bank. Or the central bank will buy more government bonds.
b. increase spending = 400/5=$80 billion.
c.the government has to borrow to the public. It will have the crowding-out effects. Interest rate will rise. The spending is the same.
d.It might go the classic way such as increase velocity of money,or adjust wage rate or value of marginal product by raising productivity. Or it might use only monetary policy, increase money supply, lower interest rate, lower reserve ratio.That won't affect the budget deficit.