Question

Suppose the government, in an effort to avoid an increase in the deficit, votes for a budget neutral tax cut policy. Assume the marginal propensity to consume (MPC) is equal to 0.85 and taxes are cut by $8 billion. Round answers to the nearest billion, and specify decreases as a negative number.
A. By how much will government spending change?
B. What is the resulting change in the equilibrium level of real GDP?

Answer 1

PART A:

The government has voted for budget neutral tax cut policy in order to avoid the enhancement in the deficit. Thereby, government spending will be reduced by an amount of $8 billion.  

PART B:

The calculation for fall in GDP is as follows:  

$\text { Change in } G D P=\frac{-M P C}{1-M P C}$

Multiply with change in government expenditure,

$\Rightarrow\frac{1}{1-0.85} \rightarrow \text { multiply with }(-8)=-53.33 \text { billion }$

Thus, if the government expense is reduced by $8 billion then fall in GDP is by $53.33 billion  

EFFECT ON GDP DUE TO REDUCTION OF TAX:

$\text { Change in taxes }=\frac{-M P C}{1-M P C}$

Multiply with change in tax,

$\Rightarrow \frac{-0.85}{1-0.85} \rightarrow \text { multiply with }(-8)=45.33 \text { million }$

Thus, when the taxes are reduced by $8 billion, then GDP shows an increase by $45.33 billion.

Therefore, change in equilibrium level of real GDP = -$8 billion ( -53.33 billion + 45.33 billion).  

Answer 2

a. The spending of the government is going to fall by 53.3b dollars following the decrease.

b. There would be a raise in the Gdp By 45.3 Million following the fall in taxes.

The summary of the question

Using the multiplier formula

1/1-mpc

mpc = 0.85

1/1-0.85

= 6.67

Government expenses fell by 8 dollars = -8

-8 * 6.67

= -53.3 billion

We conclude that the fall in government spending by 8 dollars led to a fall in GDP by -53.3 billion dollars.

b. The tax multiplier

-mpc/1-mpc

= -0.85/1-0.85

= -5.67 * - 8

= 45. 3 million

So there is a GDP raise of 45.3 million due to the fall in taxes.

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