In each of the following cases, either a recessionary or
inflationary gap exists. Assume that the aggregate supply
curve is horizontal, so that the change in real GDP arising
from a shift of the aggregate demand curve equals the size
of the shift of the curve. Calculate both the change in government purchases of goods and services and the change
in government transfers necessary to close the gap.
a. Real GDP equals $100 billion, potential output
equals $160 billion, and the marginal propensity to
consume is 0.75.
b. Real GDP equals $250 billion, potential output
equals $200 billion, and the marginal propensity to
consume is 0.5.
c. Real GDP equals $180 billion, potential output
equals $100 billion, and the marginal propensity to
consume is 0.8.
The Correct Answer and Explanation is:
To determine the required change in government purchases and government transfers to close either a recessionary or inflationary gap, we use the expenditure multiplier concept from Keynesian economics. When the aggregate supply curve is horizontal, any change in aggregate demand translates directly into a change in real GDP.
Formulas:
- Expenditure Multiplier (for government purchases) = 11−MPC\frac{1}{1 – MPC}
- Tax/Transfer Multiplier = MPC1−MPC\frac{MPC}{1 – MPC}
- Gap = Potential Output – Actual Real GDP (positive for recessionary gap, negative for inflationary gap)
a. GDP = $100B, Potential Output = $160B, MPC = 0.75
- Gap = $160B – $100B = $60B (Recessionary)
- Multiplier = 11−0.75=4\frac{1}{1 – 0.75} = 4
- Transfer Multiplier = 0.750.25=3\frac{0.75}{0.25} = 3
Required Increase in Government Purchases: 604=15 billion\frac{60}{4} = 15 \text{ billion}
Required Increase in Government Transfers: 603=20 billion\frac{60}{3} = 20 \text{ billion}
b. GDP = $250B, Potential Output = $200B, MPC = 0.5
- Gap = $200B – $250B = –$50B (Inflationary)
- Multiplier = 11−0.5=2\frac{1}{1 – 0.5} = 2
- Transfer Multiplier = 0.50.5=1\frac{0.5}{0.5} = 1
Required Decrease in Government Purchases: 502=25 billion\frac{50}{2} = 25 \text{ billion}
Required Decrease in Government Transfers: 501=50 billion\frac{50}{1} = 50 \text{ billion}
c. GDP = $180B, Potential Output = $100B, MPC = 0.8
- Gap = $100B – $180B = –$80B (Inflationary)
- Multiplier = 11−0.8=5\frac{1}{1 – 0.8} = 5
- Transfer Multiplier = 0.80.2=4\frac{0.8}{0.2} = 4
Required Decrease in Government Purchases: 805=16 billion\frac{80}{5} = 16 \text{ billion}
Required Decrease in Government Transfers: 804=20 billion\frac{80}{4} = 20 \text{ billion}
Explanation (300 words):
In Keynesian economics, a key tool for managing macroeconomic fluctuations is fiscal policy, which includes changing government spending and transfers. When the aggregate supply curve is horizontal, as assumed here, the entire shift in aggregate demand directly changes real GDP without affecting prices. Thus, the focus is solely on real output gaps.
A recessionary gap occurs when actual real GDP is less than potential output. This indicates underutilized resources and unemployment. The government can stimulate demand by increasing purchases or transfers. Conversely, an inflationary gap occurs when real GDP exceeds potential output, creating demand-pull inflation. In this case, the government needs to reduce spending or transfers to cool down the economy.
The multiplier effect amplifies fiscal actions. For example, with an MPC (marginal propensity to consume) of 0.75, each dollar of government spending leads to four dollars of increased GDP. Transfers, however, affect consumption less directly, hence the smaller multiplier.
In case (a), a recessionary gap of $60 billion exists. A $15 billion increase in government purchases or a $20 billion increase in transfers would restore equilibrium. In case (b), an inflationary gap of $50 billion requires a $25 billion cut in spending or a $50 billion cut in transfers. Case (c) has a large inflationary gap of $80 billion; cutting spending by $16 billion or transfers by $20 billion would be necessary.
These calculations highlight how fiscal policy can be tailored to economic conditions, using known multipliers to predict the impact on GDP and efficiently restore economic balance.