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In: Economics

Suppose the federal government increases taxes by $750 million. By how much should GDP change if...

Suppose the federal government increases taxes by $750 million. By how much should GDP change if the MPC = 0.90? Use an AS/AD model to show this impact on the economy.

Solutions

Expert Solution

Tax Multiplier= –MPC/(1–MPC)= –0.90/(1–0.90)= –9.

Change in Aggregate Demand= Increase in Taxes× Tax Multiplier

Change in aggregate demand= $750 billion× –9= –$6750 billion

So due to an increase in the taxes by $750 billion, the aggregate demand in the economy would decrease by $6750 billion.

In the framework of AS/AD model, this would lead to a a leftward shift in the aggregate demand (AD) curve.

Now since we don't know the shape of the supply curve we cannot tell exactly by how much the GDP has changed.

However, if the aggregate supply curve is horizontal or perfectly elastic, then the GDP would exactly decrease by $6750 billion.

But if the aggregate supply curve is upward sloping then the GDP would decrease by an amount less than $6750 billion

Both the cases of shown in the diagram below

Rahul Sunny answered 3 months ago
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