Question

Consider a hypothetical economy in which households spend $0.50 of each additional dollar of their after-tax income. The expenditure multiplier for this economy is___.

Suppose that this economy is experiencing a recession. The government would like to stimulate aggregate demand and is deciding whether it should increase its spending by $1 billion or reduce income tax by $1 billion. Assume other things remain constant, and the marginal propensity to consume remains at 0.5.

Before any multiplier effect takes place, a $1 billion increase in government spending will increase the aggregate demand by $____ billion, while a $1 billion reduction in income tax will increase the aggregate demand by $____ billion.

Now consider the effect of each fiscal policy after the multiplier effect is complete. A $1 billion increase in government spending will result in a total increase of aggregate demand by $____billion, whereas a $1 billion reduction in income tax will result in a total increase of aggregate demand by $_____billion.

Keynesians believe that the multiplier effect of an increase in government spending will be (less than/greater than/equal to) that of a tax cut of the same amount.

True or False: A government spending increase can generally begin to impact the economy more rapidly than a tax cut.

True

False

Answer 1

household spend 0.50 of its income . so MPC=0.05

Multiplier is=k=1/1-MPC= 1/1-0.50= 1/0.5=2

b) before multiplier effect the increase in governmnet spending will increase by $1 billion where as the tax reduction will only increase 0.5 billion

c) after introduction of multiplier when there is an increase in G then the over all increase is 1000000000*1/0.5=2000000000

for tax reduction of 1 billion= 1000000000*-0.5/0.5=-1000000000

d) Keynesians believe that the multiplier effect of an increase in government spending will be greater than that of a tax cut of the same amount.

e)  A government spending increase can generally begin to impact the economy more rapidly than a tax cut is true.