Question

D. Show why a $100 increase in government purchases of goods and services will have a larger effect on real GDP than a $100 increase in government transfers or a $100 decrease in taxes by completing the accompanying table. The economy has a marginal propensity to consume (MPC) of 0.6.

When answers aren’t whole dollars round each answer to two (2) decimal places (e.g., 51.6678 = 51.67) before summing in 18 – 20. All submitted answers should also be entered with two (2) decimal places.

The table below shows what happens when either government spending (G) or transfer payments (TR) are increased by $100 or taxes (T) are decreased by $100. In the first round the increase in government spending (G) immediately increases GDP by $100 (since the government purchased goods and services). It also immediately increases disposable income (YD) by $100 since the government spending becomes income to someone.

When transfer payments are increased by $100, or taxes (T) are decreased by the same amount GDP does not increase in the first round as no goods or services were purchased. All a change in transfer payments or taxes does in the first round is change disposable income (YD).

In the second round the same thing occurs in all three cases. Since YD increased by $100 in Round 1 consumption will increase by $60 in Round 2. This results because people will spend 60% of their change in income and save the other 40% (MPC = 0.6). This round GDP increases by the $60 that consumers spend on goods and services in all three cases. YD also increases by $60 as the money that consumers spend becomes income to someone else.

In Round 3 consumers will spend 60% of the $60 increase in disposable income from Round 2 ($36). Fill in the table below for additional rounds. (Remember to round your answers to two decimal places.) Then sum the changes in GDP for the 10 rounds.

Again, notice that fiscal policy only causes a change in GDP for a change in G in the first round. The same size change in TR or T does not cause a change in GDP in the first round. Also note that after the first round all changes in GDP are the result of changes in C. You only need to total the ? GDP columns.

If you have any trouble with 18 – 22 please reread the above.

? G = $100 (MPC = 0.6)				? TR = $100 (MPC = 0.6)			? T = - $100 (MPC = 0.6)
Rounds	? G (or C)	? GDP	? YD	? TR (or C)	? GDP	? YD	? T (or C)	? GDP	? YD
1	? G = $100	$100	$100	? TR = $100	$0	$100	? T = - $100	$0	$100
2	? C = $60	$60	$60	? C = $60	$60	$60	?C = $60	$60	$60
3	? C = $36	$36	$36	? C = $36	$36	$36	? C = $36	$36	$36
4
5
6
7
8
9
10
Total	X		X	X		X	X		X

Using the formula for the multiplier for changes in government purchases, for changes in transfers, and for changes in taxes calculate the total change in real GDP due to a $100 increase in government purchases, a $100 increase in transfers, and a $100 decrease in taxes.

21. The spending multiplier is ________. The transfer payment multiplier is ________ and the tax multiplier is ________.

22. The change in GDP resulting from a $100 increase in government spending is $________. The change in GDP resulting from a $100 increase in transfer payments is $________. The change in GDP resulting from a $100 decrease in taxes is $________.

[Your answers in 22 should be close to your answers for 18 to 20. Using a multiplier saves one from having to determine the results for many rounds and then summing.]

Answer 1

Answer...
21)we know aggregate spending multiplier=1/1-mpc=1-1-0.6=1/.4=2.5
Transfer multiplier=mpc/1-mpc =.6/1-.6=.6/.4=1.5
Tax multiplier=-mpc/1-mpc=-0.6/1-0.6=-0.6/0.4=-1.5 here negative sign denote the inverse relationship between GDP and tax. I.e. Tax increase will lead to decrease in GDP.
22)If government spending increases by $100 than change in GDP is multiplier*change in spending=2.5(100)=250.
Similarly change due to transfer=transfer multiplier*change in transfer=1.5(100)=150 increase in GDP due to increase in tranfer by 100.
Decrease in tax will increase the GDP and increase in GDP=-1.5(-100)=150