Chapter 4R, Problem 3FRQ

a)

To determine

The question requires us to determine the type of gap the Macrolandian economy is experiencing and suggest the policy used to correct the gap.

Answer to Problem 3FRQ

The Macroland economy is currently experiencing a recessionary gap and to close this gap, expansionary fiscal policy will be used.

Explanation of Solution

Generally, two types of the gap are possible in an economy:

Recessionary gap: when the current production level is below the potential output level.

Inflationary gap: when the current production level is above the potential output level.

So, the Macroland economy is currently experiencing a recessionary gap as it is producing $100 million below its potential output.

To close the recessionary gap, the government would use the expansionary fiscal policy. The government either increases its spending or decreases the tax rates while using the expansionary fiscal policy.

Economics Concept Introduction

A potential output level represents the optimal production level in an economy by using the given resources. If current production is below the potential output, then this means the economy is not utilizing its current resources.

b)

To determine

The question requires us to determine the value of the spending multiplier.

Answer to Problem 3FRQ

The value of the spending multiplier is 5.

Explanation of Solution

Given, MPC = 0.8

Spending multiplier will be:

  $\begin{array}{c}\frac{\Delta Y}{\Delta AS}=\frac{1}{1-MPC}\\ =\frac{1}{1-0.8}\\ =\frac{1}{0.2}\\ =5\end{array}$

Therefore, the value of the spending multiplier is 5.

Economics Concept Introduction

Spending multiplier shows the impact of change in aggregate spending on the real GDP. The expression for spending multiplier is the following:

  $\frac{\Delta Y}{\Delta AS}=\frac{1}{1-MPC}$

c)

To determine

The question requires us to determine the value of change in government taxes to reach equilibrium in the long run.

Explanation of Solution

Given, MPC = 0.8

  $\Delta Y=\$100$

To achieve more than $100 million in output, the government needs to change the taxes by $20 million in the economy.

A change in taxes is part of the change in aggregate spending. The result is:

  $\begin{array}{c}\frac{\Delta Y}{\Delta AS}=\frac{1}{1-MPC}\\ \frac{100}{\Delta T}=\frac{1}{1-0.8}\\ \Delta T=100\times 0.2\\ =20\end{array}$

d)

To determine

The question requires us to compare government spending and change in taxes to correct the gap.

Explanation of Solution

The government can change its spending either by increasing its spending or by reducing the tax rates in the economy. Generally, the government doesn’t change both variables simultaneously. So, a change in spending should be equal to a change in taxes.