Question

(c) Assume that current real gross domestic product falls short of full-employment output by $500 billion and the marginal propensity to consume is 0.8. (i) Calculate the minimum increase in government spending that could bring about full employment. (ii) Assume that instead of increasing government spending, the government decides to reduce personal income taxes. Will the reduction in personal income taxes required to achieve full employment be larger than or smaller than the government spending change you calculated in part (c)(i) ? Explain why.

Answer 1

we have MPC 0.8

and GDP Gap = $500

i) Minimium increase in government spending = GDP gap / spending multiplier

Spending multiplier = 1/1-MPC = 1/1-0.8 = 5

so increase in government spending = 500 /5 = $100 billion.

ii) amount of reduced tax = gdp gap / tax multiplier

tax multiplier = MPC / 1- MPC = 0.8 /1-0.8 = 0.8/0.2

tax multiplier = 4

reduced in personal tax = 500 / 4 = $125

so , the reduction in personal income tax would be larger than the government spending to achieve the full employment. because the mltuplier for government spending is higher than a tax multiplier because people generally save money rather than expense it. so tax multiplier is always smaller than a spending multiplier.