Question

The government is deciding whether to increase government spending by $75 or decrease taxes by $75. If the marginal propensity to consume is 85%, which will be more e ective? In other words, which will increase total spending more? Show all work.

Answer 1

Given: marginal propensity to consume(MPC) = c = 85% = 0.85

increase in government spending = ΔG = $75

decrease in taxes = ΔT = -$75

The govenment multiplier is given by:

ΔY/ΔG = 1/1(1-c)

ΔY = ΔG/(1-c)

ΔY = 75/(1-0.85)

ΔY = 500

Due to increase in government spending by $75, the total spending would increase by $500.

The tax multiplier is given by:

ΔY/ΔT = -c/(1-c)

ΔY = -cΔT/(1-c)

ΔY = (-0.85*-75)/(1-0.85)

ΔY = 425

Due to decrease in taxation by $75, the total spending would increase by $425.

Thus, an increase in government spending by $75 would increase the total spending more.