Application: • Use the spending multiplier model to answer the following and ill

Question

Application:

• Use the spending multiplier model to answer the following and illustrate each with a AD/AS model. Assume a Keynesian AS curve.

1. If the MPC = 0.75 determine how much of a tax rebate the government would have to grant to stimulate the economy by 100 billion dollars.

2. Imagine that instead of a one-time tax rebate the government decides to lower the payroll tax to achieve the same outcome as above. Will the total decrease in taxes need to be higher or lower than what you calculated in #1 above? Why?

3. If the MPS = 0.40, how much would total spending in the economy increase if the government spends 100 billion dollars more on a new interstate highway project.

4. Say the MPC = 0.90 and the government wishes to increase spending by 25 billion dollars but simultaneously maintain a balanced budget. How much must spending and taxes increase to achieve this result?

Explanation / Answer

1,

The multiplier is 1 / (1 - MPC) = 1 / MPS = 1 /0.25 = 4

The tax multiplier will be -3. Consider the simple Keynesian model with GDP = C + I + G and C = .75 (GDP - T) Since GDP = .75 GDP - 0.75 T + I + G, we have: .25 GDP = - 0.75 T + I + G, or multiplying through by 4: GDP = -3.0 T + 4 I + 4 G

tHE GOVERNMENT WILL HAVE TO STIMULATE ECONOMY BY 33.33

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