The formula for a hypothetical country\'s GDP is GDP = G+I+C+X, where G is gover

Question

The formula for a hypothetical country's GDP is GDP = G+I+C+X, where G is government, I is investors, C X stands for an international business division, and C stands for consumers. Assume that the government increases its spending by $220 billion, and at the same time, the government implements a tax increase of the same amount ($220 billion) to pay for the cost of the additional spending. Also, assume that the tax increases causes C to fall by $140 billion. If the multiplier is 2.5, what will be overall effect on the economy of both increasing spending and raising taxes to pay for the cost of the spending? Will there be economic growth or contraction?

Explanation / Answer

When government purchases and taxes are raised by the same amount, then the multiplier is termed as Balanced Budget Multiplier. It has a value of 1 if the taxes imposed are lump-sum in nature. Therefore, any increase in the government spending is equally matched by an increase in the taxes, negating any multiplied effect of income. Hence income rises by the same amount as the government expenditure does.

But here, it is given that the multiplier is 2.5. And the fall in consumption is $140 billion. Interestingly, Consumption functions entails the tax payment such that Consumption C = C' + b(Y -Taxes). So in the equation:

C + I + G + X = Y, G rises by $220 billion which will be taken exogenously. And the rise in taxes should be ignored as they automatically reduces the consumption. Observe that

Multiplier = change in Y/ change in G (Tax effect is adjusted in consumption)

2.5*change in G = change in Y

2.5*220 = change in Y = $550 billion. But this reduces the consumption by $140 billion. So the net increase or expansion in income is $550 b - $140 b = $410 billion.

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