The purpose of this exercise is to examine how countercyclical stabilization policy attempts to "lean against the wind" or change the prevailing level of aggregate demand

A media report states: "Firms cut back on investment spending causing a recession." Prior to the recession assume the economy of Keynesland was producing at its potential real GDP and the price level was stable. The decrease in I_G created a negative GDP gap, actual real GDP is $100 billion below potential real GDP. Policymakers decide to use discretionary fiscal policy to increase aggregate demand.

POLICY OPTION 1: A change in government purchases.

Predict how much government purchases (G) would have to change in order to return the economy to its full-employment level of real GDP. Assume the economy's marginal propensity to consume or

MPC = 0.90 and that there is no crowding-out effect.

a.To close the recessionary gap government purchases must _____increase__________ by $_____25_ billion.

Formula: 100= x (triangle)G

100/4=(triangle) GThe multiplier is 4

25=(triangle G)

GDP=Multiplierx G

POLICY OPTION 2: A change in taxes.

Predict how much tax revenues would have to change in order to return the economy to its full-employment level of real GDP. The MPC = 0.90 and there is no crowding-out effect.

b.To close the recessionary gap consumption (C) must _______________ by $______ billion.

Formula: GDP=Multiplierx C

To achieve this change in the level of consumption spending

c.tax revenues must _______________ by $______ billion

d.which will _______________ disposable income by $______ billion

Formula: MPCx Income= C

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