Question

Assume that a hypothetical economy with an MPC of 0.8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $40 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt (i.e., maintaining the budget balance at its current value).

Answer 1

Ans) If MPC= 0.8 then the government multiplier will be or the effect of government spending on income will be :

1/1-MPC = 1/1-0.8

= 5

∆Y=5*40

= $200 billion

So the net effect of government spending will be increase in income in whole economy by $200.

And the government should cut taxes by:

-MPC/1-MPC or -MPC/MPS

So in this question the tax amount will be cut by :

-0.8/1-0.8

= - 0.4

And in actual amount -0.4*40

= $16 billion

By $16billion the government need to cut taxes so that the same aggregate demand can be increase.

Here the government multiplier is 5 so the taxes should be increase by 4 if government's goal is not to increase outstanding debt or want to maintain balanced budget at its current value. And the amount 4 come from (5-1) because the tax multiplier is negative and in absolute terms it is one less then government spending multiplier.

So by implications;

4*40= 160

$160billion amount should be increased if government doesn't want to increase its outstanding debt in the economy.