Fiscal multipliers The blue line on the following graph shows the aggregate expe
ID: 1203239 • Letter: F
Question
Fiscal multipliers The blue line on the following graph shows the aggregate expenditure line tor a hypothetical economy. The graph also shows a 45-degree line. Initially the economy is the equilibrium with real GDP at $100 billion. The marginal propensity to consume (MPC) In this economy is 0.8. Tool tip: You can place the green line (triangle symbols) on the graph in order to help you answer this question, but you won't be graded on where you place the line. Suppose the government were to increase government purchases by $20 billon without changing the level of net taxes. This would shift the aggregate expenditure line by.After the multiplier proem has run its course, the new level of equilibrium output will be, Implying that the value of the relevant multiplier is. Now, suppose the government were to decrease net taxes by $20 billion without changing the level of government purchases. This would -shift the aggregate expenditure line by. After the multiplier process has run its course, the new equilibrium output will be. Implying that the value of the relevant multiplier is. Compare your results from the previous questions, for a given magnitude of fiscal policy (in this case, a $20 billion increase in government purchases or a $20 billion decrease in net taxes), the magnitude of the change caused by the increase in government purchases is the magnitude of the change caused by the decrease in taxes. What explains this result? When the government increases spending, it creates new infrastructure. Which increases the capital stock of the country. On the other hand, tax cuts go directly to consumption, which results is less economic growth Taxes distort the incentives faced by households and firms while government purchases do not. When the government increases spending, aggregate expenditure increases by the entire amount of the increase, but when the government lowers taxes, aggregate expenditure increases by less because some of the tax cut goes to saving. The two changes must be equal, because an increase in spending must have the same effect as a decrease in taxes.Explanation / Answer
a)
With increase in government purchase the aggregate expenditure line will shift upward by $20billion.
With MPC=0.8
Multiplier=1/1-mpc=1/1-0.8=5
The change in ouput=multiplier*government expenditure=20*5=100 billion
Thus new equilibrium output=$100 billion, with multiplier of 5
b)
With decrease in the net taxes by $20 billion, the disposable income of the economy will increase and thus the consumption will increase. The net expenditure will be shift upward by the amount $32 billion a shown in the calculation below. The effect of tax cut on the government expenditure will be indirect.
Tax multiplier=-MPC/(1-MPC).
With MPC=0.8
Tax Multiplier=-0.8/1-0.8=-1.6
Thus decrease in tax of $20 billion will lead to increase in net output by 1.6*20=32 billion
Thus New Equilibrium output=$100+$32=$132 billion
c)
The magnitude of change caused by increase in the government purchases =100/32 times =3.125 to the magnitude caused by decrease in tax.
The result is explained by option C that is when government increases the spending the aggregate expenditure increases by entire amount whereas when government cut the taxes, the aggregate expenditure increases less as some tax cut goes to saving
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