In: Economics
2. Fiscal Policy options to address a recessionary gap: Suppose the economy’s MPC is .75 or 3/4.
A. If the government increases spending by $60 billion, what will the cumulative increase in AD be equal to?
B. If the government decreases taxes by $60 billion, what will the cumulative increase in AD be equal to?
MPC = 0.75
(A) Government spending multiplier = 1 / (1-MPC) = 1 / (1 - 0.75) = 1/ 0.25 = 4
Government increases the spending by $60 billion
Government spending multiplier = (Change in Output / Change in Government spending)
=> 4 = (Change in output / $60 billion)
=> Change in output = 4 * $60 billion
=> Change in output = $240 billion
Thus, the cumulative increase in AD will be $240 billion.
---------------------------------------------------------------------------------------------------------------------------------------
(B)
Tax multiplier = -MPC / (1 -MPC) = -0.75 / (1 - 0.75) = -0.75 / 0.25 = -3
Taxes decreases by $60 billion.
Tax multiplier = (change in output / change in taxes)
=> -3 = (change in output / (-$60 billion))
=> change in output = -3 * (-$60 billion)
=> change in output = $180 billion
Thus, the cumulative increase in AD will be equal to $180 billion.