Question

Suppose that the US economy is down by exactly 800 billions from its February 2020 level. Assume that the marginal propensity to consume is 0.75, and the government decides to actively interne in order to move back the economy to its February level.

      a) By how much should he government increase both government spending and taxes to move the economy by exactly 800 billions with a balanced budget?

      b). By how much should the government increase government spending to reach the same goal without increasing taxes.

      c) Between the two choices above in (a) and (b), which one is more reasonable for the current state of our economy? Why?

Answer 1

Gap in the economy = $800 billion

MPC = 0.75

a) Spening multiplier = [1 / (1 - MPC)]

Spending multiplier = [1 / (1 - 0.75)] = 4

Tax Multiplier = -(MPC / MPS) where MPC + MPS = 1

Tax Multiplier = -(0.75 / 0.25) = -3

If government spending and tax revenue rises by same amount, total multiplier effect is 4 - 3 = 1

They should raise government spending by $800 billion which will raise aggregate demans by $800 billion * 4 = $3,200 billion and raise tax by $800 billion which will reduce aggregate demand by $800 billion * 3 = $2,400 billion which result in rise in aggregate demand by $3,200 billion - $2,400 billion = $800 billion

b) Government spending = 4

They should raise government spending by $200 billion which will result in aggregate demand by $200 billion * 4 = $800 billion

c) As economy is in recessionary gap where current output is less than potential output by $800 billion, government should raise only their spending and does not raise tax because by raising their spending they just have to spend $200 billion and economy will recover itself while if they raise tax also they will have to spend $800 billion.