Question

b) Due to severe negative demand shock, US real GDP plummeted from is potential level of $900 billion to $800 billion, so the economy is new in a recession. Suppose the government plans to use expansionary fiscal polices to get the economy out of the recession.

i. Suppose the government wants to cut taxes. Obtain the tax multiplier, and determaine how much of tax cut would be needed.

ii. Suppose the government wants to increase  government spending multiplier, and determine how much of an increase in government spending be needed.

iii. Suppose the government wants to cut taxes and increase government spending. If the size of a tax cut is $20 billion, how much of an increase in government spending would be needed?

Answer 1

B) I) tax multiplier = MPC /1-MPC = 0.8/0.2 =4

Tax needed = Recessionary gap/ tax multiplier

Tax needed= 100/4=$25 billion.

ii) spending multiplier= 1/1-MPC = 1/0.2= 5

Government spending required= 100/5= $20 billion.

iii) a $20 billion of tax cut increase GDP= 20*4= $80billion.

So $20 billion is required in GDP to increase.

So government spending required= 20/5 = $4 billion.