Question

In 2001, the U.S. was in a weak recession. Potential real GDP was estimated to be $16 trillion, but the actual real GDP was $12 trillion. Congress voted to lower taxes by $2 trillion to stimulate the economy. The American Marginal Propensity to Consume was 0.60. If only consumption depended directly on real income (taxes and imports did not depend on real income), would the tax cut return the economy to full employment if the real interest rate and the price index remained constant. Show your work.

Answer 1

Ans. The recession gap = Potential GDP - Actual GDP = 16 trillion - 12 trillion = $4 trillion

Increase in GDP due tax cut = Tax multiplier * Decrease in tax

Tax multiplier = -c/(1-c)

Here, c = Marginal propensity to consume = 0.60

=> Tax multiplier = - 1.5

Therefore, increase in GDP = -1.5* (- 2 trillion) = $3 trillion

As the increase in GDP due to tax cut is $3 trillion and the recession gap is $4 trillion, so, this tax cut does not bring the economy to full employment.

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