Suppose a country\'s MPC is 0.8, and in this country, government seeks to boost
ID: 1221244 • Letter: S
Question
Suppose a country's MPC is 0.8, and in this country, government seeks to boost real GDP by either increasing government purchases by $50 billion or by reducing taxes by the same amount.
Instructions: Include a negative sign if necessary.
a. If it increases government purchases, real GDP will increase by $ ____ billion, suggesting an expenditures multiplier of ____. If the government instead lowers taxes, real GDP will increase by $ ____ billion, suggesting a tax multiplier of ____
b. Now suppose another country's MPC is 0.6, and in this country, government seeks to reduce real GDP by either decreasing government purchases by $50 billion or by raising taxes by the same amount.
If it decreases government purchases, real GDP will decrease by $ ____ billion, suggesting an expenditures multiplier of ____. If the government instead raises taxes, real GDP will decrease by $ ____ billion, suggesting a tax multiplier of . ____
c. Which of the following statements best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier?
-The tax multiplier is larger since households spend more and better than governments do.
-The tax multiplier is smaller since all governments inevitably spend more than they say they will.
-The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut.
-The multiplier effect is exactly the same since both involve government policy.
Explanation / Answer
(a) MPC = 0.8
(i) Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5
When government spending increases by $50 billion, real GDP increases by $50 billion x 5 = $250 billion
(ii) Tax multiplier = - MPC / (1 - MPC) = - 0.8 / 0.2 = - 4
When tax decreases by $50 billion, real GDP increases by $50 billion x 4 = $200 billion
(b) MPC = 0.6
(i) Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.6) = 1 / 0.4 = 2.5
When government spending increases by $50 billion, real GDP increases by $50 billion x 2.5 = $125 billion
(ii) Tax multiplier = - MPC / (1 - MPC) = - 0.6 / 0.4 = - 1.5
When tax decreases by $50 billion, real GDP increases by $50 billion x 1.5 = $75 billion
(c) The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut.
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