Question

Suppose an economy is faced with a $20 billion dollar recessionary gap. Furthermore, the marginal propensity to consume is .80 in the economy. If taxes are decreased by $1 billion dollars, then government spending needs to increase by _____________ billion?

Answer 1

Solution:

MPS = 0.80

Derive MPC:

$MPC+MPS=1$

$MPC =1-MPS$

$MPC=1-0.80$

$MPC=0.20$

Calculate the spending multiplier:

$Multiplier=\frac{1}{MPS}$

$Multiplier = \frac{1}{0.80} = 1.25$

$Increase\; in \;government \;spending=\frac{recessionary gap}{spending multiplier}$

=$\frac{20}{1.25} = 16 \;billion dollars$

Increase in Government spending needed = 16 Billion dollars