Suppose a country\'s MPC is 0.8, and in this country, government seeks to boost

Question

Suppose a country's MPC is 0.8, and in this country, government seeks to boost real GDP by either increasing government purchases by $50 billion or by reducing taxes by the same amount.

Instructions: Include a negative sign if necessary.

a. If it increases government purchases, real GDP will increase by $ ________billion, suggesting an expenditures multiplier of ________.

     If the government instead lowers taxes, real GDP will increase by $_________ billion, suggesting a tax multiplier of ______.

b. Now suppose another country's MPC is 0.6, and in this country, government seeks to reduce real GDP by either decreasing government purchases by $50 billion or by raising taxes by the same amount.

    If it decreases government purchases, real GDP will decrease by $ _______ billion, suggesting an expenditures multiplier of ________.

     If the government instead raises taxes, real GDP will decrease by $ _______ billion, suggesting a tax multiplier of ______.

c. Which of the following statements best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier?

The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut. The tax multiplier is larger since households spend more and better than governments do. The tax multiplier is smaller since all governments inevitably spend more than they say they will. The multiplier effect is exactly the same since both involve government policy.

Explanation / Answer

a) As we know change in real GDP = expenditure multiplier * change in government spending

change in real GDP = tax multiplier * change in tax

Expenditure multiplier is defined as 1 / (1-MPC)

Here

Expenditure multiplier = 1 / (1 - 0.80) = 5.

If it increases government purchases, real GDP will increase by $(5 * 50) =$250 billion, suggesting an expenditures multiplier of 5.

Tax multiplier = MPC / (1 - MPC)

Here, Tax multiplier is 0.80 / (1 - 0.20) =4

If the government instead lowers taxes, real GDP will increase by $(4 * 50) = $200 billion, suggesting a tax multiplier of 4.

b) Expenditure multiplier = 1 / (1 - 0.60) = 2.5

Tax multiplier = 0.60 / (1 - 0.60) = 1.5

If it decreases government purchases, real GDP will decrease by $(2.5 * 50) =$125 billion, suggesting an expenditures multiplier of 2.50.

If the government instead raises taxes, real GDP will decrease by $ (1.5 * 50) =$75 billion, suggesting a tax multiplier of 1.5.

c) The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut  best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier. Because the entire government spending increase goes towards increasing aggregate demand, but only a portion of the increased disposable income (resulting for lower taxes) is consumed.

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