The government wishes to close an inflationary gap by reducing real GDP by $400 billion. Assuming a tax multiplier of 4 and an income multiplier of 5, which of the following policy prescriptions would reduce the inflationary gap by $400 billion?

Question

Quizplus · Accepted Answer

To find the appropriate policy prescription, we need to use the formula for the spending multiplier, which is:

Spending Multiplier = 1 / (1 - MPC)

where MPC is the marginal propensity to consume. Since the income multiplier is 5, we can deduce the MPC as follows:

Income Multiplier = 1 / (1 - MPC)
5 = 1 / (1 - MPC)
MPC = 0.8

Therefore, the spending multiplier is:

Spending Multiplier = 1 / (1 - 0.8) = 5

This means that for every dollar decrease in government spending, real GDP will reduce by $5.

Now, let's look at the options:

A) Decreasing government spending by $400 billion and increasing taxes by $400 billion.
This would have no effect on real GDP because the decrease in government spending would be exactly offset by the increase in taxes. Therefore, this option is not suitable.

B) Decreasing government spending by $160 billion and decreasing taxes by $100 billion.
Using the spending multiplier, we can calculate that this policy prescription would reduce real GDP by:
($160 billion) x (5) = $800 billion
To offset this, we need to decrease taxes by:
($800 billion) / (4) = $200 billion
Therefore, the total policy prescription is a decrease in government spending by $160 billion and a decrease in taxes by $100 billion, which would reduce the inflationary gap by $400 billion.

C) Decreasing government spending by $40 billion and decreasing taxes by $40 billion.
Using the spending multiplier, we can calculate that this policy prescription would reduce real GDP by:
($40 billion) x (5) = $200 billion
To offset this, we need to decrease taxes by:
($200 billion) / (4) = $50 billion
Therefore, the total policy prescription is a decrease in government spending by $40 billion and a decrease in taxes by $50 billion, which would only reduce the inflationary gap by $150 billion. Therefore, this option is not suitable.

D) Decreasing government spending by $80 billion and keeping taxes the same.
Using the spending multiplier, we can calculate that this policy prescription would reduce real GDP by:
($80 billion) x (5) = $400 billion
Therefore, this option would reduce the inflationary gap by $400 billion, but it does not specify any action regarding taxes. Thus, this option is not suitable.

Therefore, the best choice for reducing the inflationary gap by $400 billion is option B: Decreasing government spending by $160 billion and decreasing taxes by $100 billion.

The Government Wishes to Close an Inflationary Gap by Reducing