Which of the following fiscal policy changes would be the most contractionary? (

Question

Which of the following fiscal policy changes would be the most contractionary? (A) a 40 billion increase in taxes (B) a10 billion increase in taxes and a 30 billion cut in government spending (C) a 20 billion increase in taxes and a 20 billion cut in government spending (D) 30 billion increase in taxes and a 10 billion cut in government spending Which of the following fiscal policy changes would be the most contractionary? (A) a 40 billion increase in taxes (B) a10 billion increase in taxes and a 30 billion cut in government spending (C) a 20 billion increase in taxes and a 20 billion cut in government spending (D) 30 billion increase in taxes and a 10 billion cut in government spending

Explanation / Answer

The contractionary fiscal policy means either there is an increase in the taxes or decrease in the government expenditure or the combination of both.

The decrease in the government spending is a more effective contractionary fiscal policy compare to increase in the taxes.

Tax multiplier = -MPC/MPS

Spending multiplier = 1/MPS

For example if MPC=0.8

MPS=1-0.8

=0.2

Spending mulitplier= 1/0.2

=5

Tax multiplier = 0.8/0.2

=4

So the change in government spending is more effective compared to the change in the tax.

It means if there is 30 billion increase in taxes and a 10 billion cut in government spending, it will be more effective contractionary fiscal policy compared to 40 billion increase in the tax.

hence option D is the correct answer.

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