Question

The economy is at the equilibrium level of output. Government spending is increased from $200 billion to $250 billion and this increase is financed by increasing taxes from $100 billion to $150 billion and, what will be the new equilibrium level of income

MPC= 0.9

Answer 1

MPC = 0.9

Government spending multiplier = 1/(1 - MPC) = 1/(1 - 0.9) = 1/0.1 = 10

Tax multiplier = -MPC/(1 - MPC) = -0.9/0.1 = -9

Change in income = spending multiplier * change in government spending

Or, change in income = 10 * ($250 billions - $200 billions)

Or, change in income = $500 billion

Change in income = tax multiplier * change in taxes = -9 * ($150 billion - $100 billion) = - $450 billion

It means, increase in government spending increases equilibrium income by $500 billion but increase in taxes decreases equilibrium income by $450 billion. So, the equilibrium income increases by $(500 - 450) billion = $50 billion.

The new equilibrium income will be $50 billion higher than the initial equilibrium income.