Technical

1) Suppose that GDP is $40 billion below its potential level. It is expected that next-period GDP will be $20 billion below potential, and that two periods from now it will be back at its potential level. You are told that the multiplier for government spending is 2 and that the effect. The increased government spending are immediate. What policy actions can be taken to put GDP back on target each period?

2) The basic facts about the path of GDP are as in problem 1. But there is now a one-period outside lag for government spending. Decisions to spend today are translated into actual spending only tomorrow. The multiplier for government spending is still 2 in the period that the spending takes place.

a. What is the best that can be done to keep GDP as close to target as possible each period?

b. Compare the ma hot GDP in this question with the path in problem 1 after policy actions have been taken.

Question 1

It is given that current contractionary gap in GDP is $40 billion, $20 billion in next period and then will come back to potential GDP, and multiplier for government expenditure is 2, that is, for every increase in $1 in government expenditure; there will be $2 increase in GDP.

Policymakers will use inflationary policy, that is, increase government expenditure of $20 billion in current period will increase GDP to target of current period then in next two periods, government will decrease its spending by $10 billion in next period to bring the GDP back to target. And after next 2 periods, government will again decrease the expenditure by $10 billion.

Step-by-step explanation

Question 2

a) The implementation of any policy in current period will be effective from next period. So, policy makers will use inflationary policy for next year, that is, increase government expenditure of $10 billion in current period will increase GDP to target for next periods, then after 1 period, government will decrease its spending by $10 billion to bring the GDP back to target after two periods.

b) The difference due to introduction of lag is that no amount of government expenditure will make any difference in current GDP. And now the difference in GDP pattern is that initially GDP could reach potential in current period, which was not possible after introduction of outside lag.