Question

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National economy is characterised by the following data: Actual level of income Y = 4000s. Potential income Yo- 4200S MPC = 0,8. Calculate: a) How should government spending be changed so that the economy reaches its potential level of income? b) How should the government change the level of taxes to achieve a potential output level?

Answer 1

National economy is characterized by: - Actual level of income y = $ 4000 potential income y_0 = $ 4200 Mpc = 0.8 Solution a) the potential income ($ 4200) is greater then actual level of income ($ 4000) i.e ($ 4200 - $ 4000) = 200 (recession gap) spending multiplier = 1/ 1 -MPC = 1/1 -0.8 spending multiplier = 5 Tax multiplier = -MPc /1 -mpc = -0.8/0.2 tax multiplier = -4 since the is a recession gap of $ 200 Government spending should be increased by an amount: - = Recession gap/Spending multiplier = 200 /5 = $ 40 so, government spending should be increased by $ 40 so the economy reaches its potential level of income. B) Government decrease taxes by an amount: - = Recession gap/Tax multiplier = 200/-4 = -$ 50 so, Government change the level of taxes or should be decreases by - $ 50 to achieve a potential output level.