Econ 251 Principles Of

Econ 251 Principles Of

Econ 251 Principles Of

Analyze the Keynesian demand management in the context of Trickstoland's economy, which currently produces $450 billion and experiences 12% cyclical unemployment. Determine the potential GDP, the GDP gap, the effects of fiscal policy measures such as changes in government spending and taxes, and their respective multipliers based on given consumption, import functions, and autonomous investments and government spending.

Paper For Above instruction

The analysis of Keynesian demand management provides essential insights into how fiscal policy tools can mitigate economic downturns and stabilize output levels. The case of Trickstoland offers a valuable example, combining macroeconomic variables related to unemployment, potential GDP, consumption, imports, and government policies. In this paper, I will explore each part of the problem step by step, starting with the calculation of potential GDP and the GDP gap, then progressing to the fiscal multipliers and policy adjustments necessary to eliminate the output gap.

Potential GDP and the GDP Gap in Trickstoland

Given the current output level of $450 billion and cyclical unemployment at 12%, with the natural rate of unemployment at 10%, we can start by estimating the potential GDP. Cyclical unemployment reflects the deviation of actual unemployment from the natural rate, causing actual output to fall below potential output. The formula linking unemployment and output gap through Okun's law can be expressed as:

GDP gap percentage ≈ -2 × (Actual unemployment rate - Natural rate of unemployment)

Substituting the given unemployment rates:

GDP gap percentage ≈ -2 × (12% - 10%) = -2 × 2% = -4%

This indicates that actual GDP is 4% below its potential. Therefore, the potential GDP (Y*) can be calculated as:

Y* = Actual GDP / (1 + GDP gap percentage) = 450 billion / (1 - 0.04) = 450 billion / 0.96 ≈ 468.75 billion

The GDP gap itself—representing the difference between potential GDP and actual GDP—is:

GDP gap = Y* - Y = 468.75 billion - 450 billion = 18.75 billion

Consumption and Import Functions and Equilibrium GDP

The consumption function is given as C = 400 + 0.95Yd. Since disposable income Yd equals total income minus taxes (T), and taxes are not specified explicitly in the problem, for simplicity, assume T is proportional or fixed such that Yd ≈ Y. Similarly, imports are modeled as M = 120 + 0.25Yd. These functions suggest that consumption is highly responsive to disposable income, and imports increase with income, indicating an open economy.

In an open economy, aggregate demand (AD) is the sum of consumption (C), investment (I), government spending (G), and net exports (X - M). Given the autonomous nature of investment (I) and government spending (G), and exogenous exports (X), the equilibrium condition is:

Y = C + I + G + (X - M)

Expressing consumption and imports as functions of Y:

C = 400 + 0.95YM = 120 + 0.25Y

Thus, net exports (NX) are:

NX = X - M = X - (120 + 0.25Y)

Derivation of Fiscal Multipliers

From the equilibrium condition and assuming X is fixed, the equilibrium GDP can be derived:

Y = C + I + G + X - M

Y = (400 + 0.95Y) + I + G + X - (120 + 0.25Y)

Rearranged as: 

Y - 0.95Y + 0.25Y = 400 - 120 + I + G + X

(1 - 0.95 + 0.25)Y = 280 + I + G + X


0.3Y = 280 + I + G + X


Y = (280 + I + G + X)/0.3

Government expenditure multiplier:

The partial derivative of Y with respect to G is:

dY/dG = 1 / 0.3 ≈ 3.33

Investment multiplier:


The derivative of Y with respect to I is similarly:


dY/dI = 1 / 0.3 ≈ 3.33

Tax multiplier:


Tax affects disposable income, thus influencing consumption. The marginal propensity to consume (MPC) is 0.95, so the tax multiplier is negative and equal to:


dY/dT = - MPC / (1 - MPC + m), where m is the marginal import prop. Assuming the marginal import is 0.25,


then,


dY/dT = - 0.95 / (1 - 0.95 + 0.25) = - 0.95 / 0.3 ≈ -3.17


Closing the GDP Gap Using Fiscal Policy


The GDP gap of approximately $18.75 billion can be closed through coordinated fiscal policy — either by increasing government spending or decreasing taxes. Using the multipliers derived, the required changes are calculated as:


ΔG = GDP gap / dY/dG = 18.75 billion / 3.33 ≈ 5.63 billion


ΔT = GDP gap / dY/dT = 18.75 billion / -3.17 ≈ -5.92 billion


Meaning, the government must increase spending by roughly $5.63 billion or enact tax cuts worth approximately $5.92 billion to eliminate the output gap.


Conclusion


In conclusion, applying Keynesian demand management principles reveals that Trickstoland’s economy is currently below its potential GDP by approximately $18.75 billion. The estimated fiscal multipliers indicate that an increase in government expenditure or a reduction in taxes could effectively close this gap, with the approximate required increase in government spending being $5.63 billion. These measures underscore the importance of fiscal policy tools in stabilizing output and reducing unemployment during downturns, especially in labor-surplus and open economies like Trickstoland. Implementing such policies could help return the economy to its potential output, thereby fostering economic stability and growth.


References
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