government is currently operating with an annual budget deficit of $40 billion.

Question

government is currently operating with an annual budget deficit of $40 billion. The government has determined that every $10 billion reduction in the amount of onds it issues each year would reduce the market interest rate by 0.05 percentage point. Furthermore, it has determined that every 0.10 (one-tenth) percentage point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to $5 billion. The marginal propensity to consume is 0.75. Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price level, it must generate a net leftward shift in the aggregate demand curve equal to $20 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? billion. (Enter your response rounded to two decimal places) Hint: How much new private investment spending is induced by each S10 billion decrease in government spending Enter your answer in the answer box. TUTORS Type here to search

Explanation / Answer

Question 1

It has been stated that aggregate demand has to be shifted to the left by $20 billion.

This means AD is in excess by $20 billion.

Excess AD = $20 billion

MPC = 0.75

Calculate Multiplier -

Multiplier = 1/1-MPC = 1/1-0.75 = 1/0.25 = 4

Calculate the desired fiscal restraint -

Desired fiscal restraint = AD excess/Multiplier = $20 billion/4 = $5 billion

Calculate the desired increase in taxes -

Desired increase in taxes = Desired fiscal restraint/MPC = $5 billion/0.75 = $6.67 billion

The government should increase taxes by $6.67 billion.

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