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Answer :
An d) increase in government spending by $125 would help return the economy to potential output.
This is because with an MPC of 0.8, the multiplier effect is 5. Thus, the required increase in spending to close a $500 GDP gap is $100, and $125 is the closest option. To solve this, we need to increase the equilibrium GDP by $500 ($2,500 - $2,000).
Given that the marginal propensity to consume (MPC) is 0.8, we can calculate the multiplier using the formula 1/(1-MPC). Therefore, the multiplier is 5 (1 / (1 - 0.8)).
Next, we determine the required change in government spending to achieve a $500 increase in GDP. Since each dollar of government spending increases GDP by the multiplier, we divide the GDP gap by the multiplier:
$500 / 5 = $100
However, since this matches none of the given options exactly, the closest valid option is D. Increase government spending by $125, which would overshoot but still move the GDP closer to potential output.
complete question : Actual output is $2,000, potential output is $2,500, and the marginal propensity to consume (MPC) is 0.8. Which policy action will most likely return the economy to potential output?
A. Increase taxes by $125.
B. Increase government spending by $500.
C. Decrease taxes by $125.
D. Increase government spending by $125.
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