How much money should the government spend in government expenditures to eliminate this gap?

tiPtRaN: How much money should the government spend in government expenditures to eliminate this gap?
Calculate the GDP gap if in an economy the unemployment rate is 9.5%, MPC = .9, and the Full employment GDP = $ 10,800.

Calculate the regular expenditure multiplier and the net tax multiplier.

How much money should the government spend in government expenditures to eliminate this gap?

Answers and Views:

Answer by Capo Crimine
That is so easy. Just match it to whatever we have spend in the Iraq war.

Or maybe the Iraqis are more important right now than us? WE wouldn’t be in this mess if the war already had ended.

Answer by Anon_204
The regular expenditure multiplier (assuming a closed economy and lump sum taxes) is: 1/(1-MPC) ==> 10

The tax multiplier (again assuming a closed economy and lump sum taxes): -MPC/(1-MPC) ==> -.9/.1 = -9

As for the gap, according to Okun’s law, unemployment will be 1% point above the natural rate for every 3% that output is below potential output.

I can’t tell from the question what the to assume for the unemployment rate at full employment. To keep things simple I’ll use the Beveridge estimate of 3% structural unemployment. If you’re using the NAIRU, you would choose 0%.

Therefore, 9.5% unemployment is 6.5% above the potential rate. This imples a 19.5% gap between full employment GDP and actual GDP. The gap is therefore .195 x 10,800 = 2,106.

To close the gap, increasing spending by $ 210.6 or decrease taxes by $ 234.

As an editorial aside, its important to keep in mind that a fundamental weakness of this model is that it assumes the MPC is a fixed parameter. Any reasonable, micro based model of spending vs saving will allow consumers to adjust savings and spending to smooth consumption.