Question

Question 1: Fiscal Policy
Suppose the economy is in a recessionary gap, and the government reponds by conducting an
expansionary fiscal policy.
a. What are the three fiscal policy options available to the government in its attempt to close
the recessionary gap?
b. Suppose the marginal propensity to consume is 0.75. Calculate the effect of a $1,000
increase in government purchases on real GDP, and then calculate the effect of a $1,000
tax cut on real GDP. Why does a $1,000 tax cut generate a smaller multiplier effect than
a $1,000 increase in government purchases?

Answer 1

(a) Following are the three fiscal policy options to close the recessionary gap.

• Increase government spending
• decrease taxes
• increase transfer payments.

(b) MPC = 0.75

Government spending multiplier = 1 / (1 - MPC) = 1 / (1-0.75) = 1 /0.25 = 4

Government increases purchases by $1000

Government spending multiplier = (change in real GDP / change in government spending)

=> 4 = (change in real GDP / $1000)

=> change in real GDP = 4 *$1000

=> change in real GDP = $4000.

Hence, the real GDP will increase by $4000 due to increase in government purchases by $1000.

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Tax multiplier = -MPC / (1-MPC) = -0.75 / (1-0.75) = -0.75 / 0.25 = -3

Tax decreases by $1000.

Tax multiplier = (change in real GDP / change in taxes)

=> -3 = (change in real GDP / (-$1000))

=> change in real GDP = -3 *(-$1000)

=> change in real GDP = $3000

Hence, the real GDP will increase by $3000 due to decrease in taxes by $1000.

A $1,000 tax cut generate a smaller multiplier effect than
a $1,000 increase in government purchases because all amount of government spending increase is used in economy but household saves some part of their tax cut (so not all the portion of tax cut is used in the economy). Therefore, the increase in real GDP through tax cut is smaller than the increase in real GDP through increase in government spending.