Equilibrium GDP is $200 billion. Potential GDP is $100 billion. The PAE = 40 +0.8(GDP). To close the output gap, the government needs to implement a(n)_fiscal policy. The government should_taxes by_.

Question

a. contractionary. increase. $30 billion

b. expansionary. decrease. $30 billion

c. expansionary. increase. $25 billion

d. contractionary. increase. $25 billion

Answer 1

Hi Ghassan,

The answer here would be D - The government should implement a contractionary fiscal policy to raise taxes by 25 billion.

Because potential GDP is less than Equilibrium GDP, we know that we will have to use contractionary fiscal policy. Contractionary fiscal policy indicates a government will raise taxes.

Because PAE = 40 + .8(GDP), we know that the MPC=.8. We use 1/(1-MPC) to find the multiplier which we find to be 5. We then use the Tax Multiplier, Tax = MPC * Multiplier, to find the multiplier on taxes. Tax = .8 * 5 = 4. Then use the below equation to figure out how much the government needs to tax. We know that the Change in GDP is 100 because that is the difference of Equilibrium and Potential GDP, or the gap that we need to close by increasing taxes.

Change in GDP = Change in Taxes * Tax Multiplier

100 = Change in Taxes * 4

Change in Taxes = 25 Billion