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What would be the effect of an increase of $100 billion in government spending on an...

What would be the effect of an increase of $100 billion in government spending on an $1,000 billion economy whose members exhibited a 15% savings rate coupled with a 10% net tax rate? What would be the effect of the $100 billion increase in government spending on the economy if the savings in the economy were to decrease to 5% and transfer payments were to increase by $50 billion to $100 billion?

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Answer #1

(1)

MPS = Savings rate = 15% = 0.15

MPC = 1 - MPS = 1 - 0.15 = 0.85

Multiplier = 1 / [1 - MPC x (1 - Tax rate)] = 1 / [1 - 0.85 x (1 - 0.1)] = 1 / [1 - (0.85 x 0.9)] = 1 / (1 - 0.765) = 1 / 0.235

= 4.26

Therefore, when government spending increases by $100B, Income increases by ($100B x 4.55) = $455B.

New level of income = $(1,000 + 455)B = $1,455B

(2)

New MPS = 0.05

New MPC = 1 - 0.05 = 0.95

New value of multiplier = 1 / [1 - (0.95 x 0.9)] = 1 / (1 - 0.855) = 1 / 0.145 = 6.90

Increase in autonomous income due to $100B increase in government spending = ($100B x 6.9) = $690B

Increase in induced income due to $50B increase in transfer payments = ($50B x MPC) = ($50B x 0.95) = $47.5B

Net increase in income = $(690 + 47.5)B = $737.5B

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