In: Economics
We have the following information
Real GDP = $4500 billion
Potential GDP = $4600 billion
So, the gap is of $100 billion
Part 1) Government spending is increased by $35 billion. So, the value of multiplier needed to reach the potential GDP is following
Increase in GDP = Increase in Government Spending × Multiplier
$100 billion = $35 billion × Multiplier
Value of Multiplier = 2.86
Part 2) The increase in government spending will shift the aggregate demand curve upward to the right resulting in increase in income level and price level. The aggregate demand will initially increase directly by the amount of increase in government spending and thereafter through the multiplier effect as consumption and income levels rise.
Part 3) The formula for Spending Multiplier is following
Spending Multiplier = 1/(1 – MPC) where MPC is marginal propensity to consume. We know the value of Multiplier is 2.86.
2.86 = 1/(1 – MPC)
2.86 – 2.86MPC = 1
2.86MPC = 1.86
MPC = 0.65
The Formula for Tax Multiplier is following
Tax Multiplier = MPC/(1 – MPC)
Tax Multiplier = 0.65/(1 – 0.65)
Tax Multiplier = 0.65/0.35
Tax Multiplier = 1.86
So, the amount of change in the taxes needed to create the equivalent effect of increase in government spending is following
Increase in GDP = Decrease in Taxes × Tax Multiplier
1000 billion = 1.86(Decrease in Taxes)
Decrease in Taxes = $537.63 billion