Question

Suppose that the government’s budget deficit is $ 200 billion and the equilibrium level of output is $ 8000 billion. The government wants to increase the equilibrium level of output from $ 8000 billion to $ 8100. The government spending multiplier is 5, the tax multiplier is -4 and taxes are autonomous (lump-sum). To achieve $ 8100 with no change in budget deficit, how much should government spending and/or net taxes increase? (Δ refers to “change in”)

Answer 1

Accroding to balanced budget multiplier concept, in order to keep the budget balance unchanged while increasing the equilibrium level of output, the government spending and taxes should be increase by the amount government want to increase the equilibrium level of output.

The government wants to increase the equillibrium level of output by $100 billion (i.e., from $8000 billion to $8100 billion), the government spending and taxes should increase by $100 billion each to achieve no change in budget deficit.

Government soending multiplier = ΔY / ΔG

=> 5 = ΔY / $100 billion

=> ΔY = 5 * $100 billion

=> ΔY = $500 billion.

Increase in government spending by $100 billion, leads to increase in equilibrium level of output by $500 billion.

Tax multiplier = ΔY / ΔT

=> -4 = ΔY = $100 billion

=> ΔY = -4 * $100 billion

=> ΔY = -$400 billion

Increase in taxes by $100 billion, leads to decrease in equilibrium output by $400 billion.

Net change in equilibrium level of output = $500 billion + (-$400 billion)

=> Net change in equilibrium level of output = $100 billion.

Answer: ΔG = $100 billion

ΔT = $100 billion