Question

Assume that a hypothetical economy with an MPC of 0.75 is experiencing severe recession. Instructions: In part a, round your answers to 2 decimal places. Enter positive numbers. In part b, enter your answers as whole numbers. a. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? $ billion. How large a tax cut would be needed to achieve the same increase in aggregate demand? $ billion. b. Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt (because it maintains a balanced budget, G = T).

Answer 1

Answer:

a-1. Amount of rise in government expenditure required = $6.25 billion

a-2. Tax multiplier = -3

b. The combination is as follows:

Increase in spending = $25 billion

increase in taxes = $25 billion

Explanation:

a-1. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? $ billion.

Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 4

Amount of rise in government expenditure required = Change in aggregate demand / Spending multiplier = $25 / 4 = $6.25 billion

a-2. How large a tax cut would be needed to achieve the same increase in aggregate demand? $ billion.

Tax multiplier = - MPC / (1 - MPC) = - 0.75 / (1 - 0.75) = -3

Amount of tax cut required = Change in aggregate demand / Tax multiplier = $25 / (-3) = $8.33 billion

b. Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt (because it maintains a balanced budget, G = T).

The amount is the amount of the balanced budget, which has a multiplier of one. This indicates that spending and taxes need be increased by $25 billion each to boost GDP by $125 billion. Therefore, the combination is as follows:

Increase in spending = $25 billion

increase in taxes = $25 billion