7. Suppose that the MPC is 0.80 and the government was considering two possible

Question

7. Suppose that the MPC is 0.80 and the government was considering two possible fiscal actions: either raising government expenditures on goods and services by $50 billion, or raising the lump-sum tax collected by S50 bllion a. What would be the effect on equilibrium GDP of using policy 1 alone. b. What would be the effect on equilibrium GDP of using policy 2 alone. What would be the effect on equilibrium GDP of using both policies simultancously? Explain the cconomic reasons why you find this effect.

Explanation / Answer

a) Equillibrium GDP increases = G/(1 - MPC) = 50/0.2 = $250 bn

b) Equillibrium GDP decreases = T x - MPC/(1 - MPC) = 50 x -0.8/0.2 = - $200 bn (negative sign indicates a decrease in equillibrium GDP)

c) When both these policies are used simultaneously:

Equillibrium GDP increases = 250 - 200 = $50 bn

Increase in G leads to increase in aggregate expenditure ( AE = C + I + G + NX), this leads to an increase in aggregate demand and output/GDP, increased GDP leads to an increase in consumption which again leads to an increase in output/GDP. Thus, there is a multiplier effect on income where multiplier = 1/MPC.

Increase in lump-sum tax decreases the disposable income and as a result consumption decreases. This again leads to a multiplier effect which acts to decrease the equillibrium GDP and the multiplier = -MPC/(1-MPC).

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