Question

If the government decreases taxes by $4500 in an economy where the marginal propensity to consume is 15%, what happens to each of the following? Do they rise or fall? By what amounts? Give a brief written explanation. a. Public saving b. Private saving c. National saving d. Investment

Answer 1

Answer 1

(a) Public saving = T - G where T = taxes and G = government spending. Here T decreases by 4500

=> Public Saving will decrease by $4500

(b) Private Saving = Y - C - T where Y = Income.

Here MPC = 15% = 0.15 => tax Multiplier = -MPC/(1 - MPC) = -0.15/(1 - 0.15)

Thus, $1 decrease in tax willr esult in increase in Income by 0.15/(1 - 0.15)

So, $4500 decrease in tax will result in increase in Income by (0.15/(1 - 0.15))*4500 = 794.12

So, Private Saving will increase by 4500 + 794.12 = $5294.12

(c) National Saving = Private Saving + Public Saving

Thus, Change in National Saving = 5294.12 + (-4500) = 794.12

Thus National Saving will increase by $794.12

(d) At equilibrium we have National Saving = Investment(Assuming economy is closed).

Thus, Increase in national income will result in increase in Investment.

Hence, Investment will also increase by $794.12