Question

Imagine you are in the American council of Economic Advisors. And the new president wants to increase GDP BY $500 Billion.

(Given the MPC is 0.8 and there is a govt. budget deficit of $400 Billion)

You are debating two different policy proposals. The first proposal is to increase government spending. The second proposal is to decrease taxes. For both proposals answer the following:

(1) What is the required change in G and in T

(2) What is the impact of the policy on the govt. budget deficit.

Answer 1

Government multiplier = 1/(1-MPC) = 1/(1- 0.8) = 1/0.2 = 5

Tax multiplier = -MPC//(1-MPC) = -0.8/(1- 0.8) = -0.8/0.2 = -4

1) Change in GDP needed = 500 Billion

Change in GDP = government multiplier x Change in G

500 = 5 x Change in G

Change in G = $100 Billion

A $100 Billion increase in government expenditure will take economy to required level

Change in GDP = Tax multiplier x Change in T

500 = -4 x Change in T

Change in T = 500/-4 = -$125 Billion

A decrease in Tax Revenue by $125 billion will take economy to required level

2)

Budget deficit after increase in spending = 400 + 100 = $500 Billion

Government deficit increases by $100 billion to $500 Billion

Budget Deficit after decrease in taxes = 400 + 125 = $525 billion

Government deficit increases by $125 billion to $525 Billion