Question

Question 3: Suppose federal government decreases taxes by (ΔT= 10 million) and increases government spending by (ΔG = 20 million), as a result output is changed by (ΔY).

a. (10 points) Assuming that the Federal reserve changes money supply such that the interest rate stays constant and marginal propensity to consume is MPC= 0.6. What is the change in output

(ΔY)? What is ΔY ? What is ΔY? Show your work. ΔT ΔG

b. (10 points) If the fed does not change money supply, do you expect the effect of the changes in tax and spending to be larger or smaller? Explain why?

Answer 1

= 10 million (fall in taxes)

= 20 million (increase in government spending)

Both are the ways for expansionary fiscal policy

a) Changes in money supply with interest rates held constant, the effect of changing government spending and taxes is assessed using the simple expenditure multiplier.

Government spending multiplier = 1/1-MPC = 1/1-0.6 = 1/0.4 = 2.5

Thus Increase in government spending by 20 million increases the GDP by 2.5*20 = 50 million.

Similarly, Tax multiplier = MPC / 1- MPC = 0.6/ 0.4 = 1.5

Thus decrease in taxes by 10 million increases the GDP by 1.5*10 = 15 million.

Total impact on GDP, = 50 + 15 million = 65 million

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b) Money supply is held constant, the effect of changes in fiscal policy is assessed using fiscal policy multiplier

Fiscal policy multiplier (FPM) examines the change in output for a given change in fiscal policy indicator, given constant money supply.

FPM has a larger impact on output than a simple expenditure or tax multiplier because it takes into account the interest rate impacts on investment that changes because of the changes in the demand for money.

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