How Government Spending Affects Full Employment in a Model Economy

Understanding the Impact of Government Spending on Full Employment

Multiplier: The multiplier effect in economics refers to the idea that any change in autonomous spending will have a magnified effect on aggregate demand and output in the economy. In this case, the marginal propensity to consume (mpc) is given as 0.8, which means that 80% of any increase in income will be spent.

Calculating the Multiplier: The multiplier formula is calculated as 1 / (1 - mpc). Therefore, in this model economy, the multiplier would be 1 / (1 - 0.8) = 5.

Output Gap: The output gap is the difference between the current GDP and the potential GDP, representing the gap between actual output and maximum possible output. In this scenario, the current GDP is $100 million, and the potential GDP is $60 million, resulting in an output gap of $40 million.

Amount of Change in Government Expenditure Needed: To calculate the amount of change in government expenditure required to reach full employment, we divide the output gap by the multiplier. In this case, $40 million divided by 5 gives us $8 million.

Implications of Potential GDP being Less than Current GDP: When the potential GDP is less than the current GDP, it signifies that there is excess demand in the economy, leading to inflationary pressures. To combat this and reach full employment, government spending must be reduced by $8 million.

Therefore, in a model economy with an mpc of 0.8, a reduction of government spending by $8 million is necessary to reach full employment and reduce the inflationary gap.