Question

[In all cases in which you are asked to illustrate with a graph, be sure to draw it carefully and clearly label all curves and axes.]

Suppose that: C = c0 + c1YD

T = t0 + t1Y [0 < t1 < 1]

YD = Y – T

That is, taxes now consist of a combination of lump-sum taxes (t0) and income taxes (t1Y). G and I are determined exogenously.

a) Solve algebraically for equilibrium output. That is, derive the formula with Y on the left hand side and everything else on the right hand side.

b) What is the (new) formula for the expenditure multiplier?

c) Is this multiplier smaller or larger than in the simpler case in which t1 = 0?

d) In light of your answer to part c, explain why the income tax often referred to as an “automatic stabilizer.”

Answer 1

d)

Automatic stabilizer are those variables which reduces the value of multiplier and thereby reduces fluctuation in GDP so when  t1 is not equal to 0 then value of expendirure multiplier is less than when t1 = 0 . Therefore t1 i.e. income tax is referred as an automatic stabilizer.