Assume that a hypothetical economy with an MPC of 0.8 is experiencing a severe r

Question

Assume that a hypothetical economy with an MPC of 0.8 is experiencing a severe recession.

By how much would government spending have to rise to shift the aggregate demand curve rightward by $50 billion?

Instructions: Round your answer to two decimal places.

$ billion

How large a tax cut would be needed to achieve the same increase in aggregate demand?

Instructions: Round your answer to two decimal places. Enter a positive value.

$ billion

Determine one possible combination of government spending increases and tax increases that would accomplish the same goal.

Increase spending by $ billion and increase taxes by $ billion.

Explanation / Answer

MPC= 0.8 means the spending multiplier is 1/(1-mpc) = 1/ (1- 0.8) = 1/ 0.2 = 5 and the tax cut multiplier is mpc/ (1-mpc) = 0.8/ (1-0.8)= .8/.2= 4
So to get an increase in aggregate demand of $25 billion, increase in govt spending required is $ (25/5) = $5 billion. If the tax cut route is followed, to increase aggregate demand by $25 billion, a tax cut of $ (25/ 4)= $6.25 billion will be required.
The difference is because in the first round itself a govt spending increase of $5 billion leads to an increase in aggregate demand by the Govt. by $5billion, where as when the tax cut of $ 5 billionis given, the taxpayers do not increase their aggregate demand by $6.25 billion, but only by $5 billion as they save (1-0.8)*6.25 = $1.25 billion of the tax relief of $6.25 billion.

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