Question

The marginal propensity to consume is 0.5 as above. The federal government wants to increase GDP by $100 billion. By how much should government spending be increased? Suppose instead that the government wants to achieve the same goal of increasing GDP by $100 million. Assuming lump-sum taxation, what is the required tax cut in order to reach the target GDP?

Answer 1

Government spending multiplier = 1/(1- MPC) = 1/(1 - 0.5) = 1/0.5 = 2

Change in GDP = change in government spending * spending multiplier

Or, $100 billion = change in government spending * 2

Or, Change in government spending = $50 billion

Therefore, the government spending should be increased by $50 billion.

Tax multiplier = -MPC/(1 - MPC) = -0.5/(1 - 0.5) = -0.5/0.5 = -1

Change in real GDP = change in taxes * tax multiplier

Or, $100 million = change in taxes * -1

Or, change in taxes = - $100 million

Therefore, the government needs to cut taxes by $100 million.