Question

Assume that political instability around the world causes American business firms to decrease business investment signaling the start of a recession in the economy. How would a recession impact the federal budget? If real GDP drops to $800 billion while potential GDP is $1,200 billion and the marginal propensity to consume is .75, then Calculate the minimum change in government spending that could close the recessionary gap. Show your work. Calculate the minimum change in personal income taxes that could close the recessionary gap. Show your work. How will the change in real interest rates caused by either action in part B impact economic growth in the United States?

Answer 1

Answer and Explanation:

According to the scenario, computation of the given data are as follows:-

a). Because of the recession in economy American firms started decreases their business investment its indicate slowdown to the economy and less spending of the money by people because of the unemployment. To stimulate the economy the government has to increase the government spending and cut down their taxes. So because of this reason the federal budget will be deficit.

B) Increase In GDP Needed is

= Potential GDP - Real GDP Drop

= $1200 Billion - $800 Billion

= $400 Billion

Marginal Propensity to Consume(MPC) = .75

As we know that

Marginal Propensity to Save(MPS) = 1 - MPC

= 1 - 0.75

= 0.25

And,

Multiplier of Government Spending = 1 ÷ MPS

                                                           = 1 ÷ 0.25

                                                           = 4

Minimum Change in Government Spending is

= Increase in GDP Needed ÷  Multiplier of Government Spending

= $400 Billion ÷ 4

= $100 Billion

Therefore the government spending should be increased by $100 billion

c) Tax Multiplier is

= - Marginal Propensity to Consume(MPC) ÷  Marginal Propensity to Save(MPS)

= -0.75 ÷ 0.25

= -3

Minimum Change in Personal Income Tax

= Increase in GDP Needed  ÷ Tax Multiplier

= $400 billion ÷ -3

= $133.33 billion

For closing the recessionary gap tax collection should be decrease by $133.33 billion.

d) The change in real interest rates will caused by either of the action in part B generate deficits and this deficits has financed by loans. example-additional borrowing increase the demand of loanable funds, which will increase interest rates.