Question

The equilibrium level of real GDP is \(\$ 1,000\) billion, the full-employment level of real GDP is \(\$ 1,250\) billion, and the marginal propensity to consume \((M P C)\) is \(0.60 .\) The fullemployment target can be reached if government spending is a. increased by \(\$ 60\) billion. b. increased by \(\$ 100\) billion. c. increased by \(\$ 250\) billion. d. held constant.

Short answer

The correct increase in government spending required to reach the full-employment target is \(b. increased by \$100\ billion\), as calculated using the spending multiplier and the given equilibrium level of real GDP, full-employment level of real GDP, and the marginal propensity to consume (MPC).

Step-by-step solution

Understanding the Problem

We are given the equilibrium level of real GDP (\$1,000 billion), the full-employment level of real GDP (\$1,250 billion) and the marginal propensity to consume (MPC = 0.60). The problem asks us to find the increase in government spending that would bring the economy to its full-employment level of real GDP.

Calculate the Spending Multiplier

The spending multiplier is a measure of the impact a change in government spending will have on real GDP. It is calculated as follows: Spending multiplier = \(\frac{1}{1 - MPC}\) Plugging in the given MPC value: Spending multiplier = \(\frac{1}{1 - 0.60} = \frac{1}{0.40} = 2.5\)

Calculate the Required Increase in Government Spending

Now that we have the spending multiplier, we can calculate the required increase in government spending to reach the full-employment level of real GDP. To do this, we will use the following formula: Increase in government spending = \(\frac{Full\ employment\ level\ of\ real\ GDP - Current\ equilibrium\ level\ of\ real\ GDP}{Spending\ multiplier}\) Plugging in the given values: Increase in government spending = \(\frac{\$1,250\ billion - \$1,000\ billion}{2.5} = \frac{\$250\ billion}{2.5} = \$100\ billion\)

Choose the Correct Answer

Now, we will compare our answer with the given options to find the correct answer. a. increased by \$60 billion b. increased by \$100 billion c. increased by \$250 billion d. held constant Our calculated increase in government spending is \$100 billion, which matches with option b. Therefore, the correct answer is: b. increased by \$100 billion.

Key concepts

Equilibrium Level of Real GDP

The equilibrium level of real GDP is essential in understanding overall economic stability. It represents the total value of goods and services produced in an economy at a given time when spending intentions match production. At the equilibrium level, aggregate demand equals aggregate supply. This balance ensures that all produced goods are being purchased, and there is no unintended inventory accumulation.
In the provided exercise, the equilibrium level of real GDP is set at $1,000 billion. This means that, currently, the economy is stable and the output value matches what people plan to purchase. However, this equilibrium may not always reflect optimal employment levels. If the equilibrium GDP is below the full-employment level, it suggests that the economy is operating with underutilized resources, like labor, which can lead to unemployment issues.

Full-Employment Level of Real GDP

The full-employment level of real GDP refers to the total output that an economy can sustain while utilizing all available resources efficiently, including labor. At this level, unemployment is non-existent except for the frictional and structural types which are natural and usually temporary.
The given exercise mentions a full-employment level of $1,250 billion, indicating that the economy has the potential for greater production without inflationary pressures. The gap between the current equilibrium level ($1,000 billion) and the full-employment level ($1,250 billion) signifies a shortfall, often addressed by increasing government spending to boost aggregate demand and drive the economy towards full employment.

Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume (MPC) is a critical concept in understanding consumer behavior. It measures the proportion of additional income that a person is likely to spend rather than save. Thus, it provides insights into consumption patterns in an economy. In the exercise, the MPC is given as 0.60, meaning that for every dollar of additional income, 60 cents are spent on consumption.

• An MPC of 0.60 implies significant consumer confidence and economic activity, as a majority of the income is circulated back into the economy.
• The higher the MPC, the larger the impact on economic growth from any increase in income.

This concept helps in calculating the spending multiplier, which indicates how much additional economic activity is generated from an increase in government spending.

Spending Multiplier

The spending multiplier effect is a vital mechanism in fiscal policy, showing how initial government spending can lead to a more substantial overall increase in economic activity. The multiplier depends largely on the MPC, revealing how effectively spending ripples through the economy.
Using the formula \[\text{Spending multiplier} = \frac{1}{1 - \text{MPC}}\]we determine that with an MPC of 0.60, the spending multiplier is 2.5. This indicates that each dollar of government spending can increase total GDP by \(2.50. Therefore, to address the \)250 billion gap needed to reach full employment, the government should increase its spending by \(100 billion (since \)250 billion divided by the multiplier 2.5 equals $100 billion). This effect helps policymakers decide on the scale of intervention required to stimulate economic growth and reach desired employment levels.