Question

1. If the government wants to increase spending on public works by $100 billion to stimulate the economy without increasing inflation, it would

a. decrease taxes by $100 billion.

b. increase taxes by $100 billion.

c. decrease taxes by less than $100 billion.

d. increase taxes by less than $100 billion.

e. increase taxes by more than $100 billion.

Answer 1

If MPC=0.8

MPS=1-MPC

=1-0.8

=0.2

Spending Multiplier= 1/0.2

=5

Tax multiplier=-MPC/MPS

=-0.8/0.2

=-4

As it can be seen in the calculation that spending multiplier are always greater than tax multiplier and both works in the opposite direction.

So when government wants to increase spending on public works by $100 billion to stimulate the economy without increasing inflation, it would increase the tax by $100 billion because when spending and tax revenue are same, then government budget will be balanced. In this situation equilibrium GDP will increase because effect of spending multiplier will be more than the effect of the tax multiplier.

Hence government should increase taxes by $100 billion.

Hence option b is the correct answer.