The Power of Decreasing Government Spending: Closing the Inflationary Gap

What is the impact of a decrease in government spending on an economy in an inflationary gap?

Given an inflationary gap of $500 million and a decrease in government spending of $100 million, will this policy help close the gap?

Answer:

In an inflationary gap, a decrease in government spending can help close the gap by reducing inflationary pressures and bringing the economy closer to potential GDP. With an MPC of 0.8, a decrease in government spending of $100 million will result in a decrease in consumption by $80 million, which in turn decreases aggregate expenditure by $80 million.

Explanation: In an inflationary gap, government spending needs to be decreased to close the gap and reduce inflationary pressures. If the economy is in an inflationary gap of $500 million and the government decreases spending by $100 million, it will help to close the gap. The decrease in government spending reduces aggregate expenditure, which in turn reduces inflationary pressures and brings the economy closer to potential GDP.

To determine the impact of the decrease in government spending, we need to consider the marginal propensity to consume (MPC). The MPC represents the proportion of additional income that people spend. In this case, the MPC is given as 0.8, which means that for every additional dollar of income, people spend 80 cents. With a decrease in government spending of $100 million, there will be a decrease in income by $100 million. The decrease in income will result in a decrease in consumption by 80% of the decrease in income, which is $80 million. As a result, there will be a decrease in aggregate expenditure by $80 million. This decrease in aggregate expenditure will help to close the inflationary gap by reducing inflationary pressures and bringing the economy closer to potential GDP.