Question

In the fixed-price Keynesian model, which of the following will lead to the largest increase in real GDP?

• A. a decrease in government spending of $500.
• B. an increase in government spending of $500.
• C. a balanced budget change of $500.
• D. a decrease in taxes of $500
• E. an increase in taxes of $500.

Answer 1

Since AD will change by the tax increase = tax multiplier * change in the tax

AD will change by the change in the government spending= spending multiplier * change in the government spending

Since tax multiplier= -MPC/MPS

Spending multiplier = 1/MPS

So the value of tax multiplier is less than the spending multiplier, It means when Government increases its spending and cut taxes by same amount, then real GDP will increase. It means effect of spending multiplier is more than the effect of tax multiplier.

Hence it can be said that when there is an increase in the government spending by $500, then increase in the real GDP= spending multiplier* change in G

Hence it can be said that in the fixed-price Keynesian model, an increase in government spending of $500 will lead to the largest increase in real GDP.

Hence option B is the correct answer.