Question

Assume that the consumption schedule in the US economy is given by C= $20 billion + 0.8D

Where C is consumption in billion and D is disposible income (in billion) . Answer the following

a) Obtain marginal propensity to consume (MPC) and marginal propensity to save (MPS).

b) Obtain consumption, average propensity to consume (APC) and  marginal propensity to save  (APS), when D = $200 billion.

c) obtain the tax multiplier and spending multiplier.

d) Suppose a negative demand shock caused real GDP to decrease by $100 billion. the primary goal of the government expansionary fiscal policy is to get real GDP back to its potential level.

i. Suppose the government wants to cut taxes. How much of a tax cut will be needed?

ii. Suppose the government wants to increase government spending. How much of an increase in  government spending will be needed?

iii. Suppose the government wants to reduce taxes and increases  government spending.

a. if the size of a tax cut is 15$ billion, how much of an increase in government spending will be needed?

b. Suppose the government ran its balance budget before implementing this expansionary fascal policy combination. Examine if the government runs a budget surplus or budget defit now after implementing the expansionary policy combination. How much is the budget surplus or budget decit?

Answer 1

a) MPC = 0.8

MPS = 1- MPC - 1-0.8 = 0.2

b) C = 20 +0.8*200

C = 180

APC = C /D

APC = 180 / 200 = 0.9

APS = S/ D

APS = 20 /200 = 0.1

c) Tax multiplier = - MPC / MPS

tax multiplier - - 0.8/ 0.2 = -4

spending multiplier = 1/1-MPC = 1/MPS

spending multiplier = 1/0.2 = 5

d) i) tax cut = 100 /4 = $25 billion .

ii) government spending increase needed = 100 /5 = $20 billion.

iii) a) tax cut of $15 billion will increase real GDP = 15 *4 = $60 billion.

so government spending needed= 40 /5 = $8 billion .

b) government run a budget deficit of $100 billion .