a. Two identical countries, Country A and Country B, can each be described by a

Question

a. Two identical countries, Country A and Country B, can each be described by a Keynesian-cross model. The MPC is 0.8 in each country. Country A decides to increase spending by $1 billion, while Country B decides to cut taxes by $1 billion. In which country will the new equilibrium level of income be greater? Do not forget to include the formulas you need to use to answer the question and your calculations.

b. Assume that the government reduces taxes (T). Show graphically, how this Tax cut affects the Keynesian Cross and the equilibrium income. Label your graph properly and provide additional explanations.

Explanation / Answer

a) Government purchase multiplier = 1/(1-MPC) = 1/(1-.8) = 5
Tax multiplier = - MPC/(1-MPC) = -4
Country A will have new equilibrium level of income be greater.
b)

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