An economy is operating with output $400 billion below its natural level, and fiscal policymakers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run. In what direction and by how much would government spending need to change to close the recessionary gap? Explain your thinking.

The government should increase spending in an upward direction by $80 billion.

Explanation:

The output of the economy is = $400 billion.

Given marginal propensity to consume = 4/5  or 0.8

Now use the fiscal multiplier method

ΔY/ΔG = 1/1-MPC

To increase output (Y) by 400 billion, so ΔY = 5. MPC = .8

Now, we have to insert this information into the equation and find the value of ΔG

400/ΔG = 1/1-.8

400/ΔG = 1/.2

400/ΔG = 5

400 = 5*ΔG

80 = ΔG

The government should increase spending by $80 billion.