Question

The economy is in a long-run equilibrium. The marginal propensity to consume is 0.8. In an effort to balance the budget, Congress passes a new law that would increase taxes by $100 million a year.

1. According to the Keynesian cross model, what is the predicted impact on GDP? Give a numeric answer. Then, draw a graph to illustrate your answer.
2. In the IS-LM model, what is the predicted impact of this policy on output and the interest rate? Draw a graph to illustrate your answer.
3. Are the predicted quantitative changes in GDP in part 1 and 2 the same? If yes, answer yes. If not, explain why they are not the same.
4. Predict what happens to GDP and interest rate in the long-run using the IS-LM model.

Answer 1

we have MPC= 0.8

so Tax multiplier = MPC /1-MPC = 0.8/1-0.8 = 0.8/0.2 = 4

so, tax muliplier = 4

an increase in tax by $100 million would decrease the real GDP by = 100 *4 = $400

The Real GDP would decrease by $400 million in a year after the tax multiplier takes effect.

in the IS.LM model, when the tax increase, the consumptions falls, and hence the IS curve shift to the left or inwards indicating the decrease in the real GDP and interest rates.

yes they are both same , in part 1 and part 2, the real gdp will fall by the same amount.