Question

Suppose the government decided to increase government spending (Go) by 50 million dinars, and decided to increase the fixed taxes (To) by the same amount, i.e. by 50 million dinars, and if you know that the marginal propensity to consume (mpc) is 0.75, calculate the following:

1. The effect of the increase in government spending on the level of balanced income.
2. The effect of the increase in the tax on balanced income.
3. The total effect of the effect of the increase in government spending and the increase in tax on the level of balanced income.
4. Based on the results of Section 3, what do you conclude?

Answer 1

1) Given in the question, MPC= 0.75

If the Government expenditure increases by 50 million dinars, then national income would increase to 200 million dinars.This can be obtained by using the formula for government spending multiplier.

Y= {1/(1- MPC)*G}

where Y= National Income and G= Change in Government spending

Y= {1/(1-0.75)*50} = 200 million dinars

2) Now, increase in taxes by the same amount i.e. 50 million dinars would lead to a reduction in aggregate output(national income) to (200-50)= 150 million dinars.

3)Applying the formula of tax multiplier, we obtain

Change in Real GDP= -MPC/(1-MPC)* (Change in Taxes)

RGDP= -0.75/(1-.75)*50 = -3 *50 = -150 million dinars

This happens because of change in taxes of 50 million dinars, consumption would decline to 37.5 million dinars and not 50 million dinars, since the value of MPC being 0.75( i.e 0.75 * 50= 37.5 million dinars). Reduction in comsumption by 37.5 million dinars leads to a decline in income by 150 million dinars.

4)In conclusion, the net increase in national income (200-150) becomes 50 million dinars.