Suppose the economy is experiencing an expansionary gap of $1,000 and the MPC equals 0.8.With an upward-sloping short-run aggregate supply curve, by what amount will the government decrease purchases in order to close the gap?

Question

Quizplus · Accepted Answer

To close the expansionary gap of $1,000, the government needs to decrease aggregate demand by reducing government purchases, decreasing transfer payments, or increasing taxes. Based on the MPC of 0.8, we can use the government spending multiplier formula to determine the change in government purchases needed to close the gap. The formula is:

Change in Real GDP = Spending Multiplier x Change in Government Purchases

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

Change in Real GDP = $1,000

Therefore, we can solve for the change in government purchases needed as:

$1,000 = 5 x Change in Government Purchases

Change in Government Purchases = $200

Therefore, the best choice is C) by $200, which represents the decrease in government purchases needed to close the expansionary gap.

Suppose the Economy Is Experiencing an Expansionary Gap of $1,000