Consider an economy that is currently in a recessionary gap and potential output
ID: 1203919 • Letter: C
Question
Consider an economy that is currently in a recessionary gap and potential output exceeds actual output by $500 billion. The marginal propensity to consume (MPC) in this economy is 0.8. Answer the following (a) Draw a graph showing the recessionary gap. Make sure you properly label your graph. (b) Suppose the governments decides to spend $90 billion to stimulate the economy. What is the value of the multiplier? Is this level of government spending able to close the recessionary gap? (c) Given the government spending injection of $90 billion, the recessionary gap would close for what value of the MPC?Explanation / Answer
(a) In a recessionary gap, aggregate demand curve AD1 will be lower and to the left of the long-run equilibrium aggregate demand, represented by AD0. Price level (P1) will be lower than long-run equilibrium price level (P0) and real GDP (Y1) will be lower than long run equilibrium real GDP (Y0).
The recessionary gap equals (Y0 - Y1).
(b) Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5
So, as government spending increases by $1, real GDP increases by $5.
As government spending increases by $90 billion, real GDP increases by $90 billion x 5 = $450 billion.
So, the output gap is not closed and new real GDP (output) falls short by $(500 - 450) = $50 billion.
(c)
Required multiplier = $500 billion / $90 billion = 5.56
1 / (1 - MPC) = 5.56
5.56 - (5.56 x MPC) = 1
5.56 x MPC = 4.56
MPC = 4.56 / 5.56 = 0.82