Question

  Suppose the US economy is characterized by the following behavioral equations:

C = c0 + c1*YD

YD = Y – T

Investment expenditures and Government spending are exogenously given.

GDP in 2009 was roughly $16,000 billion. As you know GDP fell by approximately 4 percentage points in 2009.

1. If the propensity to consume were 0.8, by how much would government spending have to have increased to prevent a decrease in output?
2. If the propensity to consume were 0.8, by how much would taxes have to have been cut to prevent any decrease in output?

c. Suppose Congress had chosen to both increase government spending and raise taxes by the same amount in 2009. What increase in government spending and taxes would have been required to prevent the decline in output in 2009?

Answer 1

Decrease in GDP ($ billion) = 16,000 x 4% = 400

(a)

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1/0.2 = 5

To increase GDP by $400 billion, Required increase in government spending ($ billion) = 400/5 = 80

(b)

Tax multiplier = - MPC / (1 - MPC) = - 0.8 / (1 - 0.8) = - 0.8/0.2 = - 4

To increase GDP by $400 billion, Required decrease in tax ($ billion) = 400/4 = 100

(c)

To increase GDP by $400 billion,

Required increase in government spending and decrease in tax = Required increase in GDP = $400 billion