6. Chapter 34 Suppose the government reduces taxes by $20 billion, there is no c

Question

6. Chapter 34 Suppose the government reduces taxes by $20 billion, there is no crowding out, and the marginal propensity to consume is 3/4. The initial effect of the tax reduction is a $15 billion increase in aggregate demand. The total effect of the tax cut on aggregate demand is a $60 billion increase. The total effect of this $20 billion tax cut is less than the total effect that a $20 billion increase in government purchases would be. How could the government increase aggregate demand without changing the government?s budget deficit? Increase taxes and government purchases by the same amount Decrease taxes and increase government purchases Decrease taxes and government purchases by the same amount

Explanation / Answer

Initial effect = $15 billion (Via increase in disposable income and hence, consumption)

Increase

Total effect = $60 billion (Via multiplier effect of multiplier=3. So Total effect = 3*20=60)

Increase

Total effect of tax cut is less than that of government expenditure. (Multiplier for govt expenditure=4 while that of tax cut =3)

Increasing aggregate demand without changing budget deficit:

Increase taxes and government purchases by the same amount

Budget deficit = Government expenditure - Taxes

So both have to increase by same amount to keep budget deficit same,

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