Question

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

**C = c****0 +
c****1*Y****D**

**Y****D = 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.

- If the propensity to consume were
**0.8**, by how much would government spending have to have increased to prevent a decrease in output? - 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

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