Question

If government spending is decreased by $300, taxes are increased by $300, and the MPC is 0.5, equilibrium output will change by Select one

: a. $0. b. $150. c. $300. d. $600. e. $900.

Answer 1

Government spending multiplier = 1/(1-MPC) = 1/(1-0.5) = 2

This means that $1 decrease in Government spending will result in decrease in equilibrium output by $2 and thus $300 decrease in Government spending will result in decrease in equilibrium output by $2*300 = $600

Tax multiplier = -MPC1/(1-MPC) = -0.5/(1-0.5) = 1(Note her negative sign means that there is negative relation between tax and equilibrium output)

This means that $1 increase in Tax will result in decrease in equilibrium output by $1 and thus $300 increase in Tax will result in decrease in equilibrium output by $1*300 = $300.

Thus, From decrease in government spending Equilibrium output decreases by 600 and From increase in Tax Equilibrium output decreases by 300.

Thus total change in Equilibrium Output = 300 + 600 = 900(in absolute terms) {Note actual value of this change should be negative because equilibrium output decreases)

Hence, the correct answer is (e) $900