Question

a) Explain why a $500 million increase in government purchases of goods and services will generated a bigger increase in real GDP than a $500 million increase in government transfer payments like Social Security and unemployment payments.

b) The country of Boldovia has no unemployment benefits and a tax system that only uses lump sum taxes. The neighboring country of Moldovia has generous unemployment benefits and a tax system where residents must pay a percentage of their income. Which country will experience a greater variation in GDP in response to demand shocks, positive and negative?

Answer 1

Answer :-

(A)

=> As $500 million increasing in the government purchase of should directly raises aggregate spending by $500 million then starts the multiplier in the motionn. It will increase real GDP by $500 million *1/(1-MPC).

=> A $500 million increase in government transfers like social security and employment payments will increases aggregate spending only to the extent that it leads to the increase in consumer spendingg. here Consumer spending will increase by MPC *$1 for every time $1 increase in disposable income where the MPC is < 1.

=> So a $500 millions increased in government transfers should cause increase in real GDP should only MPC times as much as to $500 million raise in government ppurchases of goods and services. It will increase real GDP by $500 million * MPC/(1-MPC).