Suppose the government levies only proportional taxes. In particular assume that

Question

Suppose the government levies only proportional taxes. In particular assume that people pay to the government 25% of their earned income. The MPC is assumed to be 0.8. (a) Compute the value of the multiplier. (b) By how much would the AD curve shift (or equivalently output Y increase) if G increased by 850 million? (c) Now suppose the government increases the tax rate. How would your answer change with respect to b)? Namely, for the same change in G, are we going to observe a lower, larger or equal shift in AD? Why?

Explanation / Answer

a. Tax Multiplier = -MPC/1-MPC = -0.8/1 - 0.8 = -0.8/0.2 = -4

Government Multiplier = 1/1-0.8 = 1/0.2 = 5

Shift in AD ot increase in Y = Government Multiplier*Increase in government spending/G

= 5*$50 million

= $250 million

c. If along with the increase of G, the government also increases Taxes, then shift in AD will be lesser then as in case b, because now along with government spending multiplier , the Tax multiplier will also be in effect and as tax multipler is of opposite sign , so it reduces the output.

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