Which of the following is the best choice to eliminate a recessionary gap if the desired fiscal stimulus is $10 billion and the aggregate demand shortfall is $100 billion,while the MPC is 0.90?

Question

Quizplus · Accepted Answer

To eliminate a recessionary gap with a desired fiscal stimulus of $10 billion and an MPC (marginal propensity to consume) of 0.90, a tax cut is needed to increase consumption and aggregate demand. The fiscal multiplier is 1/(1-MPC) = 1/(1-0.90) = 10. Therefore, to achieve a $100 billion increase in aggregate demand (closing the gap), a $10 billion stimulus is required. However, because tax cuts are less direct than government spending in stimulating aggregate demand (people might not spend all of the tax cut), you need to divide the desired increase in aggregate demand by the multiplier to find the required tax cut. The calculation for the required tax cut is $100 billion / 10 = $10 billion. However, this calculation overlooks the correct application of the multiplier effect in the context of tax adjustments. The correct calculation to determine the size of the tax cut needed to achieve the desired increase in aggregate demand, considering the multiplier effect, is to adjust the initial calculation to account for the fact that not all of the tax cut is spent. The correct answer involves recognizing that a tax cut of $11.11 billion, when considering the multiplier effect and the MPC, would be required to effectively generate the desired fiscal stimulus to close the recessionary gap. This is because the initial spending injection needs to be larger when it comes through a tax cut, as not all of it will be spent immediately or may not fully translate into aggregate demand due to the savings portion. The calculation error in the explanation highlights the necessity of understanding how fiscal policy tools, like tax cuts, interact with economic variables such as the MPC and the fiscal multiplier to influence aggregate demand.

Which of the Following Is the Best Choice to Eliminate