Question

Suppose a country's MPC is 0.8, and in this country, government seeks to boost real GDP by either increasing government purchases by $50 billion or by reducing taxes by the same amount.

Instructions: Round your answers to one decimal place when appropriate. If you are entering any negative numbers be sure to include a negative sign (-) in front of those numbers.

a. If it increases government purchases, real GDP will increase by $ ____billion, suggesting an expenditures multiplier of _____.

     If the government instead lowers taxes, real GDP will increase by $ ____billion, suggesting a tax multiplier of____ .

b. Now suppose another country's MPC is 0.6, and in this country, government seeks to reduce real GDP by either decreasing government purchases by $50 billion or by raising taxes by the same amount.

    If it decreases government purchases, real GDP will decrease by $___billion, suggesting an expenditures multiplier of____ .

    If the government instead raises taxes, real GDP will decrease by $ _____billion, suggesting a tax multiplier of ____.

c. Which of the following statements best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier?

• a) The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut.

• b) The tax multiplier is larger since households spend more and spend better than governments do.

• c) The tax multiplier is smaller since all governments inevitably spend more than they say they will.

• d) The multiplier effect is exactly the same since both involve government policy.

Answer 1

MPC= 0.8

Increase in G or decrease in taxes= $50 billion

(a) If it increases government purchases , real GDP will increase by (1/1-0.8)(50 billion)= $250 billion , suggesting an expenditure multiplier of 1/1-MPC= 1/(1-0.8) = 1/0.2= 5 .

If the government lowers taxes, real GDP will increase by (-0.8/1-0.8)(-50 billion) = $200 billion, suggesting a tax multiplier of (-MPC/1-MPC) = (-0.8/1-0.8) = -0.8/0.2= -4.

(b) MPC= 0.6

Decrease in G or increase in taxes = $50 billion

If the government decreases , real GDP will decrease by (1/1-0.6)(50 billion)= $125 billion, suggesting an expenditure multiplier of 1/1-MPC = 1/1-0.6 = 2.5

If the government instead raises taxes , real GDP will decrease by (-0.6/1-0.6)( -50 billion)= $75 billion, suggesting a tax multiplier of (-MPC/1-MPC) = (-0.6/1-0.6)= -1.5

(c) The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut best explains the difference in magnitude of the multiplier effects between the expenditure multiplier and tax multiplier. Hence,option(A) is correct.