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Expansionary fiscal policy

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Congratulations! You've just been appointed chairman of the Council of Economic Advisors in Textland. The mpe is 0.8. There is recessionary gap of $400.

a. The government wants to eliminate the gap by changing expenditures. What policy would you suggest?

b. Your research assistant comes running in and tells you that instead of changing expenditures, the government wants to achieve the same result by decreasing taxes. What policy would you recommend now?

c. Your research assistant has a worried look on her face. "What's the problem?" you ask. "I goofed, " she confesses. "I thought taxes were exogenous when actually there's a marginal tax rate of .2." Before she can utter another word, you say, "No problem, I'll simply recalculate my answers to parts a and b and change them before I send them in." What are your corrected answers?

d. She still has a pained expression, "What's wrong?" you ask. "You didn't let me finish," she says. "Not only was there a marginal tax rate of .2; there's also a marginal propensity to import of .1." Again you interrupt to make sure she doesn't feel guilty. Again you say, "No problem," and recalculate your answers to parts a and b to account for the new information. What are your new answers?

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Solution Summary

Expansionary fiscal policy is considered.

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Congratulations! You've just been appointed chairman of the Council of Economic Advisors in Textland. The mpe is 0.8. There is recessionary gap of $400.

a. The government wants to eliminate the gap by changing expenditures. What policy would you suggest?

Solution:

Expansionary fiscal policy is appropriate when the economy is in a recessionary gap. If the government wants to eliminate the gap by changing the expenditure, then the increased spending leads to a multiplier times increase in aggregate expenditures, thereby closing the gap. Given the MPE as 0.8,

Multiplier = 1 / (1 - MPE)

= 1 / (1 - 0.8)

= 5

In order to eliminate the recessionary gap of $400, the government has to change its expenditure as follows,

$400 = multiplier * change in expenditure

So, change in expenditure = $400 / 5 = $80

Thus government has to increase its expenditure by $ 80 to eliminate the recessionary gap of $400.

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b. ...

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