Given: Suppose in an effort to stimulate aggregate demand, the government mails

Question

Given: Suppose in an effort to stimulate aggregate demand, the government mails tax rebate checks to all household, totaling $50 billion for the economy as a whole. Ignore crowding-out effect.

If the marginal propensity to consume (MPC) is 0.70, by how much would you expect these tax rebates to initially increase aggregate demand? Show your calculations step-by-step. Final answers without calculations will not receive the full credits.

Compare your answer to the one shown on the video, then answer this question:

TRUE OR FALSE: Holding other things constant, a lower MPC is bound to yield a larger impact on the initial demand.

Including the multiplier effect, what is the total effect of these tax rebates on the aggregate demand. Show your calculations step-by-step. Final answers without calculations will not receive the full credits.

Compare your answer to the one shown on the video, then answer this question:

TRUE OR FALSE: Holding other things constant, a lower MPC is bound to yield a lower impact on the total demand.

How does the total effect of this policy compare to the total effect of a $50 billion

increase in government spending? Show your calculations step-by-step. Final answers without calculations will not receive the full credits.

Explanation / Answer

Suppose the government reduces the tax by rebating a total of $50 billion for the economy as a whole. If the marginal propensity to consume (MPC) is 0.70, in the first round, people will save 30% of increased income we expect that these tax rebates will initially increase aggregate demand by 0.70*50 = 35 billion.

This is because in the first round a part of tax rebated is saved and that part is 1 - MPC = 0.3 or 30%. The rest is spent which again increases income of sellers.

Note that the Multiplier is 1/1-MPC so a lower MPC implies lower multiplier and is bound to yield a smaller impact on the initial demand. The statement is FALSE

Including the tax multiplier effect, we see that tax multiplier is -MPC/1 - MPC = -0.7/0.3 = (7/3). Hence multiplier value is (-7/3), then the total effect of these tax rebates on the aggregate demand is 50 x 7/3 = 350/3 or 116.67 billion

The statement is FALSE because holding other things constant, a lower MPC is bound to yield a higher impact on the total demand

Now the total effect of this policy is 116.67 billion increase in AD while if we compare its effect with the total effect of a $50 billion increase in government spending, we find that spending multiplier is 1/1-MPC = 10/3. Hence total effect will be 50 x 10/3 = 166.67 billion.

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