Question

Assume the marginal propensity to consume is 0.8 and potential output is $800 billion. If actual real GDP is $700 billion, which of the following policies would bring the economy to potential output? a. Decrease taxes by $25 billion. b. Decrease government transfers by $25 billion. c. Decrease taxes by $100 billion. d. Increase taxes by $100 billion.

Answer 1

Potential output = $800 billion  

Actual output = 700 billion

so to bring economy at  potential output we have to increase output by 100

MPC = 0.8

so simple tax multiplier = MPC/(1 - MPC)

= 0.8/(1 - 0.8)

= 0.8/0.2

= 4

Y/T = 4  

If taxes decrease by 25 billion then T = 25

  Y/T = 4

Y/25  = 4  

Y = 100

Hence to bring economy at  potential output taxes should be decreased by 25 billion

(a) is correct option