(4 points) Suppose the current GDP is $800 billion, potential GDP is $900 billio
ID: 1091839 • Letter: #
Question
(4 points) Suppose the current GDP is $800 billion, potential GDP is $900 billion, government spending is $100 billion, and tax revenues are $120 billion. The government multiplier is 4. a. (2 points) If the government increases spending on defense by $20 billion, ceteris paribus, GDP will [ increase | decrease ] by $ ___________ billion. Show calculations. b. (2 points) If, instead of increasing G by $20 billion, the government cuts taxes by $20 billion. Ceteris paribus, will the effect on GDP be greater than, equal to, or less than, that in (a)? Explain why.
Explanation / Answer
a. An increase in government spending will lead to an increase in GDP equal to the increase in government spending times the government spending multiplier.
Increase in GDP = $20 billion x 4 = $80 billion
b. Tax cuts increase disposable income. According to the marginal propensity to save, some portion of increased income will go to savings. Therefore the tax multiplier is different from the spending multiplier:
tax multiplier = 1
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