The GDP is $40 billion below its potential value. It is expected that next-period GDP will be $20 billion below potential and that two periods from now it will be back at its potential level. The multiplier for government spending is 2.
Now assume there is a one-period outside lag for government spending. Decisions to spend today are translate in to actual spending only tomorrow. The multiplier for government spending is still 2 in the period that the spending takes place.
a. What is the best that can be done to keep GDP as close to target as possible each period?
b. Compare the path of GDP in this question with this path:
The first step would be to change the monetary policy of the government. The low GDP is a sign of recession. When the economy is in recession, the supply of money decreases. The interest rate should be increased so as to promote investment and increase the money supply in the economy. The increased government spending is also one of the ways to increase the supply in the economy.