AS-AD and fiscal policy. The US Congress would like to increase aggregate demand

Question

AS-AD and fiscal policy. The US Congress would like to increase aggregate demand AD in the US by either increasing government purchases G bar or decreasing taxes T bar (but not both). The equilibrium in the economy is characterized by the following equations: C = C bar + mpc middot (Y - T) I = I bar - d middot (r + f bar) G = G bar T = T bar r = r bar + lembda middot pi pi = pi^e + gamma middot (Y - Y^P) + mu bar Suppose that mpc = 0.75. If the Congress wishes to increase AD by $400 billion, by how much would it have to raise government purchases G bar? By how much would it have to decrease taxes T bar to achieve the same effect?

Explanation / Answer

Government multiplier = 1/ (1-mpc) = 1/(1-0.75) = 1/0.25 = 4

Therefore, to increase AD by $400, Government expenditure should be increase by $100. Therefore increase in Y will be 4*100 = $400.

Tax multiplier = -mpc/(1-mpc) = -0.75/0.25 = -3

Therefore to increase AD vy $400, tax should be reduce by $133.33.

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