Question

Part 1 - Check Your Understanding-​​ U​ se the information in the paragraph to answer the questions. Assume that policymakers believed that the marginal propensity to consume (MPC) was 0.9.  

Following the announcement in December 2008 that the U.S. economy had been in a recession since December 2007, Congress and President Obama passed the A​merican Recovery and Reinvestment Act(ARRA) into law in February 2009. The ARRA cut taxes by $288 billion, increased government spending by $275 billion, and increased transfer payments by $224 billion. Although not fully implemented, the majority of the government spending would take place in 2010 and 2011.  

1. Calculate the maximum increase in GDP that could result from the tax cut. Show your work.  
2. Calculate the maximum increase in GDP that could result from the increase in government spending. Show your work.
3. Calculate the maximum increase in GDP that could result from the increase in government transfers. Show your work.  
4. Based on your calculations, what is the maximum change in spending from the AARA? Show your work.

Answer 1

Given that the MPC=0.90.

Multiplier=1/(1-MPC)=1/0.10=10.

With cut in taxes by $288 disposable income will increase by $288 billion and consumption will increase by $288 billion*0.90=$259.2 billion.

With increase in consumption by $259.2 billion, GDP will increase by $259.2 billion*10=$2592 billion.

With increase in government spending by $275billion, GDP will increase by $275 billion*10=$2750 billion.

Transfer payments are made to those people who consume most of the transfer payments received. So, with increase in transfer payments by $224 Billion, GDP will increase by $224 billion*10=$2240 billion.

Total stimulus to the GDP will be $2592 billion+ $2750 billion+$2240 billion = $7582 billion.