Question

1. Explain the effects of the following actions on equilibrium income (Assume that the marginal propensity to consume is 0.8).

                           a. Government purchases rise by $20 billion.

                           b. Taxes fall by $20 billion.

Answer 1

a)

Spending multiplier =1/(1-MPC)

=1/(1-0.8)

=5

Change in equilibrium income eventually =intial change in government spending * spending multiplier

=20*5

=$100 billion

the equilibrium income increases by $100 billion.

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b)

tax multiplier =-MPC/(1-MPC)

=-0.8/(1-0.8)

=-4

Change in equilibrium income eventually =intial change in tax * multiplier

=(-20)*(-4) .......... the negative sign shows a decrease

=$80 billion

THe equilibrium income increases by $80 billion