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 reduce real GDP by $400 billion, we need to use the income multiplier.

ΔY = -m * ΔT
where ΔY is the change in income, ΔT is the change in taxes, and m is the income multiplier.

We know the income multiplier is 5, so we can rearrange the equation to solve for the change in taxes:
ΔT = (-ΔY) / m

ΔY = -$400 billion, and m = 5, so:
ΔT = -(-$400 billion) / 5 = $80 billion

This means we need to decrease taxes by $80 billion to reduce the inflationary gap by $400 billion.

But we also need to use the tax multiplier to make sure the decrease in taxes doesn't lead to an increase in real GDP.

ΔY = -t * ΔG
where ΔY is the change in income, ΔG is the change in government spending, and t is the tax multiplier.

We know the tax multiplier is 4, so we can rearrange the equation to solve for the change in government spending:
ΔG = (-ΔY) / t

ΔY = -$400 billion, and t = 4, so:
ΔG = -(-$400 billion) / 4 = $100 billion

This means we need to decrease government spending by $100 billion to reduce the inflationary gap by $400 billion.

Therefore, the best choice is B, which suggests decreasing government spending by $160 billion and decreasing taxes by $100 billion.

The Government Wishes to Close an Inflationary Gap by Reducing