The Impact of Tax Cuts on Closing Recessionary Gaps

The subject question asks how much the government should cut taxes to bring the economy to its full potential if the economy is in a recession with an output gap of $1 trillion, and the AE function is AE = 0.5 + 0.8Y. In the context of a Keynesian economic model, in the face of a recessionary gap, the government can utilize fiscal policy measures, such as decreasing taxes or increasing spending, to shift the aggregate expenditure function upwards, and thus eliminate the output gap.

In this scenario, to fill a recessionary gap of $1 trillion, we consider the multiplier effect. Given the equation AE = 0.5 + 0.8Y, the expenditure multiplier here is 1/(1-0.8) =5. Therefore, a governmental tax cut of $200 billion (1 trillion / 5), would, as a result of the multiplier effect, stimulate an overall increase in income and expenditure of $1 trillion, thereby closing the output gap to revive the economy to its full potential.

Explanation:

The implementation of tax cuts plays a vital role in stimulating economic growth and closing recessionary gaps. By reducing tax rates, individuals and businesses have more disposable income, which can lead to increased spending and investment. This, in turn, boosts aggregate demand and economic activity, helping to fill output gaps and bring the economy back to its full potential.

Tax cuts are a form of expansionary fiscal policy, which aims to spur economic growth during periods of economic downturn or recession. By injecting more money into the economy through tax cuts, the government can effectively increase overall demand for goods and services, leading to increased production and employment levels.