Question

The economy's current level of equilibrium GDP is \(\$ 780\) billion. The full employment level of GDP is \(\$ 800\) billion. The multiplier is \(4 .\) Given those facts, we know that the economy faces _____ expenditure gap of _____. a. An inflationary; \(\$ 5\) billion. b. An inflationary; \(\$ 10\) billion. c. An inflationary; \(\$ 20\) billion. d. A recessionary; \(\$ 5\) billion. e. A recessionary; \(\$ 10\) billion. f. A recessionary; \(\$ 20\) billion.

Short answer

The economy faces a recessionary expenditure gap of \( \$ 5 \) billion (Option d).

Step-by-step solution

Define the Problem

We are given that the current equilibrium GDP is \( \\( 780 \) billion, the full employment GDP is \( \\) 800 \) billion, and the multiplier is \( 4 \). We need to determine the type and amount of expenditure gap.

Calculate the GDP Gap

The GDP gap is the difference between the full employment level of GDP and the current equilibrium GDP. Calculate this as: \( \text{GDP gap} = \text{Full employment GDP} - \text{Equilibrium GDP} = \\( 800 \text{ billion} - \\) 780 \text{ billion} = \$ 20 \text{ billion} \).

Determine the Type of Gap

Since the full employment GDP is greater than the equilibrium GDP, the economy output is below its potential level, indicating a recessionary gap.

Calculate the Expenditure Gap

The expenditure gap can be found by dividing the GDP gap by the multiplier: \( \text{Expenditure gap} = \frac{\text{GDP gap}}{\text{Multiplier}} = \frac{\\( 20 \text{ billion}}{4} = \\) 5 \text{ billion} \).

Identify the Correct Answer

With our calculations, the economy has a recessionary expenditure gap of \( \\( 5 \) billion. Therefore, the correct answer is option d: A recessionary; \( \\) 5 \) billion.

Key concepts

GDP Gap

The GDP Gap represents the difference between the actual output of an economy and its potential output at full employment, which we also refer to as Full Employment GDP. Imagine the economy as a car, trying to drive up to a target destination representing full employment. If the car isn't reaching that target because it's running below its potential speed, that's akin to having a GDP Gap.
Here’s how to understand it more clearly:

• If the economy produces less than its full potential, we observe a positive GDP Gap. This indicates underperformance and unused economic resources.
• Conversely, if the economy exceeds its potential, producing beyond the Full Employment GDP, the GDP Gap will be negative. However, this situation is less common and often unsustainable.

In our example, the GDP Gap was calculated as:\[\text{GDP Gap} = \text{Full Employment GDP} - \text{Equilibrium GDP} = 800 \text{ billion} - 780 \text{ billion} = 20 \text{ billion}\]This tells us the economy is underproducing by 20 billion dollars compared to what it could ideally achieve.

Multiplier Effect

The Multiplier Effect is a phenomenon where an initial change in spending leads to a larger change in the overall economic output. This effect hinges on the principle that one person’s spending becomes another’s income, which then gets spent again, creating a ripple effect throughout the economy.
Here’s a simple way to grasp the concept:

• When additional spending enters the economy, it gets re-spent multiple times, generating more income and further spending in cycles.
• The size of this effect depends on the Marginal Propensity to Consume (MPC), which is the fraction of additional income that is spent on consumption.
• A higher MPC results in a larger multiplier, amplifying the initial spending more as it circulates through the economy.

In the given exercise, the multiplier is 4, indicating that every dollar of expenditure translates into four dollars of overall economic activity. This concept is crucial for determining expenditure gaps during fiscal policy assessments.

Recessionary Gap

A Recessionary Gap occurs in an economy when there is insufficient demand to achieve full employment. This happens when the real GDP is lower than the potential GDP at full employment levels, signifying a slowdown in economic activity.
Think of it like this:

• In a recessionary gap, businesses are not fully using their resources. This often leads to higher unemployment and unused capacity in production.
• Households tend to spend less as incomes drop, which further slows economic growth.
• The gap highlights the need for policy intervention, such as stimulus spending, to boost demand and close the gap.

In our problem scenario, because the potential GDP (800 billion) exceeds actual GDP (780 billion), it indicates a recessionary gap. A recessionary gap reveals that the economy is not achieving its full potential, causing concern for policymakers.

Full Employment GDP

Full Employment GDP is the level of economic output where all available resources are utilized efficiently, and the economy operates at its potential without causing inflation.
Think of it as the sweet spot for economic performance:

• Full Employment GDP doesn't mean zero unemployment. Instead, it implies natural rates of unemployment, accounting for those between jobs or changing careers.
• It illustrates an optimal condition where resources like labor and capital are used without shortages or waste.
• A deviation from this level, in either direction, is a signal of economic imbalance. Both under-use and over-use of resources have long-term effects.

In our given exercise, the Full Employment GDP is marked at 800 billion dollars. Achieving or closely reaching this level is vital for stable economic growth, avoiding excessive inflation or recessionary pressures.