3. The multipller effect Aa Aa Consider a hypothetical dosed economy in which ho

Question

3. The multipller effect Aa Aa Consider a hypothetical dosed economy in which households spend so.80 of each additional dollar they earn and save the remaining $0.20. The marginal propensity to consume (MPC) for this economy ls multipller for this economy is , and the Suppose the government in this economy decdes to decrease government purchases by $300 billion. The decrease in government purchases will lead to a decrease in income, generating a decrease in consumption that decreases income yet again, and so on. Fill in the following table to show the impact of the change in government purchases on the first two rounds of consumption spending and, eventually, on aggregate demand. Change in Government Purchases First Change in Consumption Second Change in Consumption Total Change in Demand -$300 billion illion), the To bring about a decrease in consumption equal to the decrease in government purchases (that is, $300 b government would have to increase taxes by decrease in total demand as the decrease in government purchases, the multiplier for a tax increase (known as tax multiplier) must be taxes leads to a decrease in total demand.) billion. Since this increase in taxes would lead to the same . (Note: The tax multiplier is expressed as a negative number, since an increase in Which of the following formulas for the tax multiplier is correct and consistent with this quantitative result O Tax multiplier -MPC/ (1 + MPC) Tax multiplier = (1-MPC) /-MPC Tax multiplier =-MPC / (1-MPC)

Explanation / Answer

Marginal propensity to consume is .8 (it is change in consumption/ change in income = .8/1 = .8)

multiplier is .2 (1- MPC = 1-.8 = .2)

first change in consumption will be a decrease

second change in consumption will be an increase

the government would have to increase the taxes by 300 billion$

multiplier for the tax increase must be negative

tax multiplier = -MPC /(1-MPC)

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