Question

Suppose that the full employment level of output of an economy is Rs. 2200 million, expenditure determined level of output is Rs. 2163 million, and the marginal propensity to consume is 0.75. The deflationary gap equals Rs. _____ million (round off to 2 decimal places).

Answer 1

Correct Answer: 9.25

This is a macroeconomic problem that requires calculating the deflationary gap based on the difference between the full employment level of output and the expenditure determined level of output and the marginal propensity to consume ($\text{MPC}$).

$\text{1. Define Variables}$

Full Employment Level of Output ($Y_f$): $\text{Rs. } 2200 \text{ million}$

Actual/Equilibrium Level of Output ($Y$): $\text{Rs. } 2163 \text{ million}$

Marginal Propensity to Consume ($\text{MPC}$ or $b$): $0.75$

$\text{Required Calculation}$

The Deflationary Gap is the amount by which the aggregate expenditure falls short of the level required to achieve full employment equilibrium. It is the necessary increase in autonomous expenditure ($\Delta A$) required to close the gap between $Y_f$ and $Y$.

$$\text{Deflationary Gap} = \Delta A$$

$\text{2. Calculate the Output Gap}$

The difference between the required output ($Y_f$) and the actual output ($Y$) is the Output Gap ($\Delta Y$):

$$\Delta Y = Y_f - Y$$

$$\Delta Y = 2200 \text{ million} - 2163 \text{ million}$$

$$\Delta Y = 37 \text{ million}$$

$\text{3. Calculate the Multiplier}$

The relationship between the change in autonomous expenditure ($\Delta A$) and the resulting change in equilibrium output ($\Delta Y$) is governed by the Simple Multiplier ($\text{M}$):

$$\text{Multiplier } (\text{M}) = \frac{1}{1 - \text{MPC}}$$

$$\text{M} = \frac{1}{1 - 0.75}$$

$$\text{M} = \frac{1}{0.25} = 4$$

$\text{4. Calculate the Deflationary Gap}$

The Deflationary Gap ($\Delta A$) is calculated by dividing the Output Gap ($\Delta Y$) by the Multiplier ($\text{M}$):

$$\Delta Y = \text{M} \times \Delta A$$

$$\text{Deflationary Gap } (\Delta A) = \frac{\Delta Y}{\text{M}}$$

$$\Delta A = \frac{37}{4}$$

$$\Delta A = 9.25 \text{ million}$$

$$\text{The deflationary gap equals } \mathbf{9.25} \text{ million}$$