Real GDP equals $400 billion, the government collects 25% of any increase in real GDP in the form of taxes, and the marginal propensity to consume is 0.8. If potential output equals $250 billion, the government could close the _____ gap by decreasing government spending by _____.

Question

Quizplus · Accepted Answer

The economy is experiencing an inflationary gap since real GDP ($400 billion) exceeds potential output ($250 billion). To close this gap, the government should decrease spending. The spending multiplier is 1/(1-MPC*(1-tax rate)) = 1/(1-0.8*0.75) = 2.5. To close a $150 billion gap, the government should decrease spending by $150 billion / 2.5 = $60 billion.

Real GDP Equals $400 Billion, the Government Collects 25% of Any