Real GDP equals $200 billion, the government collects 20% of any increase in real GDP in the form of taxes, and the marginal propensity to consume is 0.8. If potential output equals $255.6 billion, the government could close the _____ gap by increasing government spending by _____.

Question

Quizplus · Accepted Answer

The gap is recessionary because actual GDP ($200 billion) is less than potential GDP ($255.6 billion). The spending multiplier is 1/(1-MPC) = 1/(1-0.8) = 5. The gap is $55.6 billion, so the government needs to increase spending by $55.6 billion / 5 = $11.12 billion. However, considering the tax rate, the effective multiplier is reduced to 4, so the required increase in spending is $55.6 billion / 4 = $13.9 billion, which is closest to $20 billion.

Real GDP Equals $200 Billion, the Government Collects 20% of Any