Suppose the Japanese economy has been experiencing slow growth. As a result, the Prime Minister, who thinks John Maynard Keynes was the greatest economist ever, has decided to increase government spending. The Prime Minister asks the head of the economic council to determine the increase in government spending necessary to bring the economy to full employment. Assume there is a GDP gap of 1 trillion yen and the marginal propensity to consume (MPC) is 0.60. What advice should the head of the economic council give the Prime Minister

The advice that the economic council has to give to the PM is that the gap is equal to 1 trillion yen divided by 2.5 or 0.4 billion

Given that the GDP gap is a trillion, the spending of the government has to be raised in order to close this gap.

This shows the presence of recession in the economy.

We find the multiplier.

= 2.5

To close this gap,

ΔY = ΔG * multiplier

100 = ΔG * 2.5

ΔG = 100/2.5

= 40

The advice that the economic council has to give to the PM is that the gap is equal to 1 trillion yen divided by 2.5 or 0.4 billion

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The recessionary gap will be equal to 1 trillion yen divided by 2.5 or 0.4 trillion yen

Explanation:

From the question, we are informed that GDP gap of 1 trillion yen and the marginal propensity to consume (MPC) is 0.60. Also, to close the GDP gap, the prime minister has decided to increase government spending. This means that there will be a recessionary gap because the actual GDP will be less than the potential GDP.

Fir the economy to be brought to its potential GDP, the spending of the government will give a stimulus to the economy. Since MPC is 0.6, the multiplier will be:

= 1/1-MPC

= 1/1 - 0.6

= 1/0.4

= 2.5

The government spending will then increase in order to close the recessionary gap as:

∆Y = ∆G × Multiplier

100 = ∆G × 2.5

∆G = 100/2.5

∆G = 40

Therefore, the recessionary gap will be equal to 1 trillion yen divided by 2.5 or 0.4 trillion yen.

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