Question

Currently, a government's budget is balanced. The marginal propensity to consume is $\backslash (0.80$. The government has determined that each additional $\backslash )10$ billion it borrows to finance a budget deficit pushes up the market interest rate by role="math" localid="1651613391961" $0.1$ percentage point. It has also determined that every role="math" localid="1651613378175" $0.1$-percentage point change in the market interest rate generates a change in planned investment expenditures equal to $\backslash (2$ billion. Finally, the government knows that to close a recessionary gap and take into account the resulting change in the price level, it must generate a net rightward shift in the aggregate demand curve equal to $\backslash )200$ billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase its expenditures? (Hint: How much private investment spending will each $\$10$ billion increase in government spending crowd out?)

Short answer

As a result, the government will have to boost its spending by $\$50$ billion to meet its goal.

Step-by-step solution

Introduction 

The given is the current balanced budget of the government

The objective is to determine how much should the government increase its expenditure

Explanation 

The proportionate change in consumption due to a proportionate change in income is referred to as marginal propensity to consume $(MPC)$.

Calculation 

We must first obtain the multiplier. Calculate the multiplier as follows:

Given: MPC is $0.80$.

Then

Multiplier $=\frac{1}{1-\mathrm{MPC}}$

$$\begin{gathered} =\frac{1}{1-0.80} \\ =\frac{1}{0.2} \\ =5 \end{gathered}$$

In order to shift the aggregate demand curve rightward by $\$200$ billion, total autonomous spending must be increased by $\$40$ billion $(\$200÷5)$.

As a result, if the government spends an additional $\$50$ billion, the market interest rate rises by $0.5$ percent, lowering the anticipated investment by $\$10$ billion. This amounts in a net increase of $\$40$ billion in overall autonomous spending.

As a result, the government will have to boost its spending by $\$50$ billion to meet its goal.