Question

Suppose Kittyville decides to change government spending under Keynes' advice. By how much must government spending change to correct for the expenditure gap (rounded to nearest billion dollars)

Answer 1

In order for the expenditure gap to be corrected, Kittyville needs to increase government spending by $20 billion.

As a result of the full employment GDP being less than the current GDP, Kittyville is experiencing a recessionary gap where they are producing below their natural capacity.

To correct it, they can increase government spending to inspire growth. The amount they need to increase government spending by is:

= GDP deficit / Multiplier

GDP deficit:

= Full employment GDP - Current GDP

= 600 - 400

= $200 billion

Multiplier = 1 / ( 1 - MPC)

= 1 / (1 - 0.9)

= 10

Increase in government spending:

= 200 / 10

= $20 billion

In conclusion, Kittyville needs to increase government spending by $20 billion.

First part of question is:

Suppose Kittyville's full-employment GDP = $600 billion, and the current equilibrium GDP = $400 billion. The MPC in this economy = 0.90.

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