a) Real GDP is currently $4,500 billion, and potential GDP is $4,600 billion. If government spending...

a) Real GDP is currently $4,500 billion, and potential GDP is $4,600 billion. If government spending increases by $35 billion, what does the multiplier equal to? Show the effect the change will have on macroeconomic equilibrium. b) By how much does taxes have to change to create the same effect?

Solutions

Expert Solution

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

Rahul Sunny answered 1 year ago

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