Question

Assumes that the marginal propensity to consume in Maldives is 0.9. For the next year it is estimated that the economy would receive investments worth of RF 50 million, government would purchase goods and services worth of RF 40 million, and taxes would be RF 40 million. Assumes exports and imports to be zero.

Questions:

If the government cuts its expenditure on goods and services by 30 million, what would be the change in equilibrium expenditure now?   

The government decided to purchase RF 40 million worth of goods and services, and to cut taxes to RF 30 million. What would be the change in equilibrium expenditure now?

The government simultaneously decided to cuts its’ both purchase of goods and services and taxes to RF 30 million. What would be the change in equilibrium, expenditure now?

Answer 1

MPC = 0.9

Government spending multiplier = [1 / (1 - MPC)] = [1 / (1 - 0.9)] = 10

Tax multiplier = -[MPC / (1 - MPC)] = 9

1) Decrease in government expenditure = 30 million

Total decrease in equilibrium expenditure would be: Decrease in government spending * Multiplier =  30 million * 10 = 300 million

2) Increase in government expenditure = 40 million

This increase in government expenditure will increase expenditure by: 40 million * 10 = 400 million

Decrease in tax = 30 million

This decrease in tax will increase expenditure by: Tax change * Tax multiplier = 30 million * 9 = 270 million

Both of these policies will change aggregate expenditure by 400 million + 270 million = 670 million

3) Decrese in government expenditure = 30 million

This decrease in government expenditure will decrease expenditure by: 30 million * 10 = 300 million

Decrease in tax = 30 million

This decrease in tax will increase expenditure by: Tax change * Tax multiplier = 30 million * 9 = 270 million

Both of these policies will change aggregate expenditure by -300 million + 270 million = -30 million