Question

Suppose the economy can be modeled as follows.

C=100+.8Y_D    I=200   

G=300                                      T=400

a) suppose full employment income is 1,600. By how much would the government have to change taxes to reach full employment? Graph it!

b) What is the tax multiplier in this case?

c) Which policy, changing taxes or changing government spending has the smaller effect on the government’s budget? Why?

Answer 1

a) suppose full employment income is 1,600. By how much would the government have to change taxes to reach full employment?

Find the aggregate expenditure

AE = C + I + G

AE = Y

Y =100+.8(Y - 400) + 200 + 300

Y = 280 + 0.8Y

0.2Y = 280

Y = 1400.

Hence, the recessionary gap is 1600 - 1400 = 200. Tax multiplier = -MPC/1-MPC = -0.8/0.2 = -4. Taxes should fall by 200/4 = 50 so that full employment GDP is attained.

b) What is the tax multiplier in this case?

Tax multiplier = -MPC/1-MPC = -0.8/0.2 = -4.

c) Which policy, changing taxes or changing government spending has the smaller effect on the government’s budget? Why?

Changing taxes because while Increase in G raises AD by full, decrease in taxes would increase dispoable income which is not entirely spent but a part of it is saved. Hence AD shifts but not by full.