Economics
Economics
4th Edition
ISBN: 9781464143847
Author: Paul Krugman, Robin Wells
Publisher: Worth Publishers
Question
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Chapter 28, Problem 6P
To determine

Concept Introduction:

Marginal Propensity to Consume (MPC): It is the proportion of amount which the consumer pays for consumption of goods and services, and it does not include the savings of the consumer.

Formula to calculate money multiplier:
MoneyMultiplier=11MPC (I)

Here:

  • MPC in marginal propensity to consume.

Formula to calculate recessionary/inflationary gap:

RecessionaryGap/InflationaryGap=PotentialOutputRealOutput (II)

Negative value shows inflationary gap whereas positive value shows recessionary gap.

Formula to calculate required change in government purchases:

Change in Government Purchases=(RecessionaryGap/InflationaryGapMoneyMultiplier) (III)

Formula to calculate transfer per dollar:

TransferperDollar=MPC1MPC×$1 (IV)

Here:

  • MPC in marginal propensity to consume.

Formula to calculate change in the government transfers:

ChangeinGovernmentTransfers=RecessionaryGap/InflationaryGapTransferperDollar (V)

a. Change in government spending and government transfer.

Given:

Real GDP equals $100 billion.
Potential output equals $160 billion.
Marginal propensity to consume is 0.75.

Substitute 0.75 for MPC in (I):
MoneyMultiplier=110.75=10.25=4

Substitute $160 billion for potential output and $100 billion for real output in (II):

RecessionaryGap=$160 billion$100 billion=$60 billion

Substitute $60 billion for recessionary gap and 4 for money multiplier in (III):

Change in Government Purchases=$60billion4=$15billion

Substitute 0.75 for MPC in (IV):

TransferperDollar=0.7510.75×$1=0.750.25×$1=3×$1=$3

Substitute $60 billion for recessionary gap and $3 for transfer per dollar in (V):

ChangeinTransfers=$60billion$3=$20billion

Therefore, there is a rise in government spending by $15 billion and there should be increase in government transfers by $20 billion.

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