1. Side effects of financing government spending Aa Aa Suppose the government of
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1. Side effects of financing government spending Aa Aa Suppose the government of Wunderbar wants to finance a $1 million increase in government spending by raising taxes. The tax increase decreases total consumers' disposable incomes by$million. If consumer spending changes by 80% of the change in consumers' income, then the net effect of the increase in government spending will be a in aggregate expenditure. $0.2 milion decrease $0.2 million increase $0.8 million increase $1 mlon decrease QNA 3$0.8 million decrease erved $1 million increase Grade It Now Save & Continue © 201 1 All rights reserved.Explanation / Answer
(1) As tax increases by $1 million, disposable income decreases by $1 million
Marginal propensity to consume (MPC) = % Change in consumption / % Change in income = 80% = 0.8
Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5
Tax multiplier = - MPC / (1 - MPC) = - 0.8 / 0.2 = - 4
As government spending rises by $1 million, aggregate expenditure (AE) increases by $5. At the same time, a rise in tax of $1 million will reduce AE by $4 million. So, net increase in AE = $(5 - 4) million = $1 million
ANSWER: $1 million increase.
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