Question

Suppose the government reduces taxes by $20 billion and that the MPC is .75

What is the total effect of the tax cut on aggregate demand?

How does the total effect of this $20 billion tax cut compare to the total effect of a $20 billion increase in government purchases? Why?

Where must the government believe the economy is presently? Draw and label a graph illustrating both where they think we are presently and the changes which will occur with the change in net taxes.

Answer 1

Ans.

a) Tax multiplier = -MPC/(1-MPC) = -0.75/(1-0.75) = -3

Change in aggregate demand = tax multiplier * Change in taxes

=> Change in aggregate demand = -3*(-20 billion) = $60 billion

Thus, aggregate demand will increase by $60 billion

b) Spending multiplier = 1/(1-MPC) = 1/(1-0.75) = 4

Change in aggregate demand = 4*20 billion = $80 billion

Thus, increase in aggregate demand due to increase in government spending is more than by decrease in tax by same amount. This is because tax cut directly increases the taxable income of the consumer and as MPC is 0.75, so, only 75% of this increase in disposable income translates to increase in aggregate demand on the other hand, government spending increase does not effect disposable income, so, fully translates into increase in aggregate demand.

c) Government cut taxes when the economy is in financial slowdown or is in recession. So, government believes that it is facing a recessionary gap i.e. ouput level is below the full employment level (Yf) and an decrease in tax will increase disposable income of households who will increase demand for goods and services and thus, shift aggregate demand curve rightwards from AD to AD'. This increases price level from P to P', increasing aggregate quantity of goods supplied and thus, increasing output level from Y to potential level of output, Yf.