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

A recessionary; \( \$5 \) billion (option d).

Step-by-step solution

Analyze the Situation

The problem statement provides the current equilibrium GDP, which is \( \\(780 \) billion, and the full employment GDP, which is \( \\)800 \) billion. The multiplier effect is given as \( 4 \). We need to determine the type of expenditure gap and its size.

Determine the Type of Expenditure Gap

Since the equilibrium GDP (\( \\(780 \) billion) is less than the full employment GDP (\( \\)800 \) billion), there is a gap that indicates the economy is not operating at full potential. This scenario represents a recessionary gap because the output is below its full potential level.

Calculate the Required Change in GDP

The required change in GDP to achieve full employment can be calculated as the difference between the full employment GDP and the current GDP. The required change is \( \\(800 \text{ billion} - \\)780 \text{ billion} = \$20 \text{ billion} \).

Calculate the Expenditure Gap

Since the multiplier is \( 4 \), the actual change in expenditure needed to reduce the gap is given by dividing the required change in GDP by the multiplier. Thus, \( \frac{\\(20 \text{ billion}}{4} = \\)5 \text{ billion} \). This is the expenditure gap.

Identify the Correct Answer

The economy faces a recessionary expenditure gap based on the analysis. The calculated expenditure gap of \( \\(5 \text{ billion} \) is the amount required to bridge the gap. The correct answer matches option (d): A recessionary; \( \\)5 \text{ billion} \).

Key concepts

Recessionary Gap

A recessionary gap occurs when the actual equilibrium GDP is less than the full employment GDP. It signals that the economy isn't producing at its maximum potential, leading to unemployment and underutilized resources. In simpler terms, a recessionary gap indicates that there's extra room for the economy to grow before it reaches its capacity.
For example, if the equilibrium GDP is $780 billion, but the full employment GDP is $800 billion, the economy is experiencing a recessionary gap. This $20 billion difference indicates that the economy is producing less than it could with its available resources.

• Recessionary gaps often lead to governmental intervention to boost economic activity.
• Increased public spending or tax cuts are common methods to mitigate a recessionary gap.
• Addressing the gap encourages higher spending and investment, leading to job growth and increased production.

Equilibrium GDP

Equilibrium GDP is the level of output where aggregate demand equals aggregate supply. At this point, there are no unplanned changes in inventories, meaning businesses are selling exactly what they're producing.
This concept is vital because it represents a stable state for the economy, unaffected by market disequilibrium forces. However, equilibrium GDP doesn't necessarily mean the economy is at full efficiency. If equilibrium GDP is lower than full employment GDP, like in our example, it suggests a recessionary gap.

• Equilibrium GDP can fluctuate based on consumer spending, business investment, government policies, and net exports.
• Changes in equilibrium GDP often drive macroeconomic policy adjustments.
• Monitoring this measure helps policymakers understand economic health and potential output changes.

Full Employment GDP

Full Employment GDP is the maximum output the economy can achieve when all resources, including labor, are used efficiently. It represents the highest level of economic activity without causing inflation.
In our exercise, the full employment GDP is set at $800 billion. This number acts as a benchmark to assess whether the economy is performing at its full potential or lagging behind. When actual GDP falls short of this level, it indicates lost opportunity.

• Reaching full employment GDP ensures maximum economic productivity and minimal unemployment.
• It is a key target for economic policies aiming to optimize resource utilization.
• Discrepancies between current GDP and full employment GDP often trigger corrective policy actions to stimulate or throttle economic activity.

Multiplier Effect

The multiplier effect explains how an initial change in spending can lead to a larger overall impact on GDP. It exemplifies the ripple effect in the economy when spending increases or decreases, magnifying the initial economic change.
The multiplier is a crucial concept in understanding how expenditure changes affect total economic output. In the exercise, the multiplier is given as 4, indicating that every dollar of initial spending results in a $4 increase in overall economic activity.

• This concept is essential for evaluating the effectiveness of fiscal policies, like government spending or tax adjustments.
• Higher multipliers mean more significant impacts from changes in spending, affecting employment and output.
• Understanding the multiplier effect helps design strategies to minimize recessionary gaps by justifying appropriate levels of fiscal interventions.