Explain why the balanced budget multiplier is equal to one (i.e., if government

Question

Explain why the balanced budget multiplier is equal to one (i.e., if government spending increases by 10 billion and taxes increase by 10 billion, equilibrium GDP increases by 10 billion). In your explanation, you may assume that the increase in government spending (G) is 10 billion, the corresponding increase in taxes (T) is 10 billion, and the Marginal Propensity to Consume (MPC) is equal to 0.8. What would provide more stimuli, a 10 billion dollar increase in government spending or a 10 billion dollar tax cut?

Explanation / Answer

Answer :- The balanced-budget multiplier is equal to one. The "positive" impact on aggregate production caused by a change in government purchases is largely, but not completely, offset by the "negative" impact of the change in taxes. The only part of the impact of the change in government purchases NOT offset by the change in taxes is the purchase of aggregate production made by the initial injection. Hence, the change in aggregate production is equal to the initial change in government purchases.

in given example, remember that spending multiplier is 1/(1-MPC) so GDP would increase due to increase in government expenditure by $50BN.

now, because tax multiplier is [ -MPC/MPS] so GDP would fall due to incfrease in taxes by $40BN.

the net effect would be increase in GDP by $10BN.

this is so happened because , the increase in aggregate production triggered by the increase in government purchases is offset by a decrease in aggregate production triggered by the increase in taxes. the increase in aggregate production stimulated by government purchases is only partially offset by the decrease aggregate production stimulated by taxes. thus , a 10 billion dollar increase in government spending provide more stimuli.

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.