Question

Consider an economy, but don't know the marginal propensity to consume (MPC) for the average person. If the government decides to increase its government spending by 1 billion dollars in education (building more public schools, etc.) To nance the increase in government spending, the government decides to increase tax by 1 billion dollars as well. How would the GDP respond to this series of change in the Goods Market Equilibrium? Explain.

Answer 1

The situation is a balanced budget situation where under fiscal policy government increases government spending and taxes by the same amount so there will be no change in budget balance and it increases the GDP by the same amount.

The GDP increases by $1 billion.

Ex.

if there is an MPC of 0.9

Spending multiplier =1/(1-MPC)

=1/(1-0.9)

=10

the change in GDP because of change in spending = change in spending * multiplier =1*10=$10 billion

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tax multiplier =-MPC/(1-MPC)

=-0.9/(1-0.9)

=-9

the change in GDP =tax change * tax multiplier =1*(-9)=-$9 billion

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the total change =10-9=$1 billion

the same change in taxes and government spending is same, and in the same direction then that policy is called balanced budget policy and it increases GDP by the same amount of change in the taxes or spending because the balanced budget multiplier is 1.

Balanced budget multiplier =spending multiplier + tax multiplier =10+(-9)=1