Question

Assume that a hypothetical economy with an MPC of 0.75 is experiencing a severe recession.

a. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion?

Instructions: Round your answer to two decimal places.

$  billion

b. How large a tax cut would be needed to achieve the same increase in aggregate demand?

Instructions: Round your answer to two decimal places. Enter a positive value.

$  billion

c. Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

Increase spending by $  billion and increase taxes by $  billion.

Answer 1

The spending multiplier is represented by 1/MPS or 1/(1-MPC)

Given MPC is .75, hence MPS= 1-0.75 = 0.25

Multiplier for case (a) is 1/0.25 = 4

Hence, Change in Spending * Multiplier= Change in Demand

Change in demand is given to be $25 billion, hence Change is spending = 25/4 = $6.25 billion

Case (b) Now we have a tax cut, and formula for multilper in case of tax cut is MPC/MPS

which in this case is 0.75/0.25 = 3

Hence Change in Tax cut = 25/3 = $8.33 billion

case (c):

Assuming the same spending multiplier of 4 times and same tax multiplier of -3, negative because we are now increasing tax instead of tax cut and same change in demand of $25 billion dollar:

Change in spending * 4 - change in tax * 3 = $25 billion

Assuming change in spending to be $10 billion only, we get increase in taxes as $5 billion and same goal of $25 billion change in demand is achieved.