Question

Using your knowledge of the IS curve and the balanced budget multiplier, answer the questions below.

Assume the following:

MPC is 0.75

Let government spending increase $500 million.

Let net taxes increase $500 million.

Using the IS/LM framework, illustrate the IS shift caused by the increase in government spending. Measured in dollars (GDP) on the horizontal axis, how much did IS shift (what is the magnitude of the horizontal shift)?

Now, on the same chart, illustrate the effect of the tax increase with a third IS curve, showing the change fromthe 2nd IS curve.....in other words, assume government spending increases first, then taxes are increased. By how much does the IS curve shift as a result of the tax increase?

At a fixed (given) interest rate, what is the overall dollar change in GDP resulting from the combined increase of government spending and taxes? Explain and show relevant computations.

Answer 1

With the value of MPC being 0.75 spending multiplier = 1/1-MPC = 1/1-0.75 = 4 and tax multiplier = -MPC/1-MPC = -0.75/0.25 = -3

When G rises by 500, Income is increased by 500*4 = 2000. This shifts the IS to the right by 2000. Next when tax is increased by 500, income is reduced by 500*-3 = -1500 so IS shifts left by 1500. This implies that the net increase in GDP is 500 which is the result we get from a balanced budget multiplier that is equal to 1 for an equal increase in G and T.

The overall dollar change in GDP resulting from the combined increase of government spending and taxes is only 500.