Question

An economy is initially at full employment, but a decrease in planned investment spending (a component of autonomous expenditure) pushes the economy into recession. Assume that the marginal propensity to consume (MPC) of this economy is 0.75 and that the multiplier is 4. How large is the recessionary gap after the fall in planned investment?

Answer 1

The recessionary gap is four times the initial decrease in planned investment.

Step-by-step explanation:

A recessionary gap occurs when an economy is below its potential GDP, resulting in high unemployment. To calculate the size of the recessionary gap after a decrease in planned investment, we can use the multiplier effect. The multiplier is calculated using the formula 1/(1-MPC). In this case, the MPC is 0.75, so the multiplier is 1/(1-0.75) = 4. With a multiplier of 4, a decrease in planned investment will lead to a decrease in equilibrium GDP that is four times larger. Therefore, the recessionary gap would be four times the initial decrease in planned investment.

Let's assume there is a $100 decrease in planned investment. Using the multiplier, the recessionary gap would be $100 * 4 = $400. So the size of the recessionary gap after the fall in planned investment is $400.