Question

C=250+0.80 (Y-T), G=200, T=130, I= 200, Both G and T are independent of income. Investment is fixed. Determine Tax multiplier

Answer 1

We know that the aggregate real expenditure is equal to aggregate real GDP. So in expenditure method Y= C+I+G+NX, where C is consumption expenditure, I is investment expenditure, G is government expenditure, NX is net export i.e export minus import. Therefore Y = 250 + 0.80(Y-T) + 200 + 200, here no export import so this part is not required. Y = 250 + 0.80(Y - 130) + 400 . Y = 650 + 0.80Y - 0.80*130 or Y - 0.80Y = 650 - 104 or 0.20Y = 546 . Therefore Y = 546/0.20 = 2730. Therefore equilibrium income is $2730. Now tax rate multiplier is calculated as - MPC/ 1- MPC = - 0.80/1-0.80 = -0.80/0.20 = -4. This minus sign is because the increase in tax decreases the income. This result implies if there increase in tax by 1 dollar the income will fall by 4 dollar.