Question

Assume that a hypothetical economy with an MPC of 0.8 is experiencing severe recession.

Instructions: In part a, round your answers to 2 decimal places. Enter your answers as positive numbers. In part b, enter your answers as whole numbers.

a. By how much would government spending have to rise to shift the aggregate demand curve rightward by $30 billion?

How large a tax cut would be needed to achieve the same increase in aggregate demand?

b. 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).

increase government spending by ____ billion

increase taxes by ____ billion

  

Answer 1

(a) MPC = 0.8

=> Government spending multiplier = 1 / (1 - MPC)

=> Government spending multiplier = 1 / (1 - 0.8)

=> Government spending multiplier = 1 / 0.2

=> Government spending multiplier = 5

In order to shift the Aggregate deamnd rightward by $30 billion. The GDP should increase by $30 billion.

Government spending multiplier = (Change in GDP / Change in Government spending)

=> 5 = ($30 billion / Change in government spending)

=> Change in government spending = ($30 billion / 5)

=> Change in government spending = $6

Hence, the government spending should increase by $6.

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Tax multiplier = -MPC / (1 - MPC)

=> Tax multiplier = -0.8 / (1-0.8)

=> Tax multiplier = -0.8 / 0.2

=> Tax multiplier = -4

In order to shift the Aggregate deamnd rightward by $30 billion. The GDP should increase by $30 billion.

Tax multiplier = (Change in GDP / Change in tax)

=> -4 = ($30 billion / Change in tax)

=> Change in tax = ($30 billion / -4)

=> Change in tax = -$7.5 billion.

Hence, the tax should decrease by $7.5 billion.

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(b) According to Balanced Budget Multiplier concept, in order maintain the budget balance at current level, there should be increase in government spending and taxes by the amount you need to increase the GDP.

Hence, Increase in government spending by $30 billion.

Increase in taxes by $30 billion.

Note: $30 billion increase in government spending will lead to increase the GDP by $150 billion (i.e., $30 billion *5 = $150 billion)

$30 billion increase in taxes will lead to decrease the GDP by $120 billion (i.e., $30 billion * -4 = -$120 billion)

=> Net change in GDP = $150 billion + (-$120 billion)

=> Net change in GDP = $30 billion.