Assume the economy has a GDP of $11,500 billion. The unemployment rate is at 7.3% and...

Assume the economy has a GDP of $11,500 billion. The unemployment rate is at 7.3% and has been slowly rising for the last 6 months. Inflation was at 2.3% one year ago but has since dropped to near 0%. The MPC in the economy is .80 and the Natural Rate of Unemployment is 4.5%. The target rate for inflation is 2%.

Why would it be better for government to solve the problem using government purchases (part c above) rather than taxes (part d above) to solve the problem?
Assuming that government does decide to use the tax policy, what could happen to cause the policy to be ineffective?

Expert Solution

A - The government should used the purchases policy rather than the taxation policy because the effect of the purchase policy is greater than tax. The value of the spending multiplier will be 5 and value of tax multiplier will be 4 here. As a result the problem could be solved early using the government purchases approach.

2 - If the tax policy is used , its effective lies on the fact that how much people decide to consume and how much to save from the increased income. If the MPC of the poeple drop and MPS rises , so that they save a greater portion of tax decrease , this will result in greater leackage and smaller expansion due to reduced multiplier. This will make the policy ineffective.

Rahul Sunny answered 2 years ago

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