1) Suppose that Congress enacts a significant tax cut with the expectation that
ID: 1189625 • Letter: 1
Question
1) Suppose that Congress enacts a significant tax cut with the expectation that this action will stimulate aggregate demand and push up real GDP in the short run. In fact, however, neither real GDP nor the price level changes significantly as a result of the tax cut. What might account for this outcome?
2) Suppose that Congress enacts a lump-sum tax cut of $750 billion. The marginal propensity to consume is equal to 0.75. Assuming that Ricardian equivalence holds true, what ist he effect on equilibrium real GDP? On saving?
Explanation / Answer
(1) This may happen when there is a complete crowding out.
If LM curve is vertical, then an expansionary fiscal policy has no effect on aggregate demand & will only increase the interest rate. As interest rate increases, borrowing becomes costlier, therefore investment demand decreases. As a result, with no growth in aggregate demand, price level also remains unchanged.
(2)
Multiplier = 1 / (1 - Marginal propensity to consume)
= 1 / (1 - 0.75) = 1 / 0.25 = 4
A $750 billion tax cut will increase disposable income by $750 billion.
If disposable income increases by $750 billion, then consumption demand increase by $750 x 0.75 = $562.5 billion.
Therefore, equilibrium real GDP will increase by $$562.5 billion.
Saving will increase by $750 billion x (1 - MPC) = $750 billion x 0.25 = $187.5 billion.
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