Consider a country with an economy whose GDP is described by the following formu

Question

Consider a country with an economy whose GDP is described by the following formula: GDP = G+I+C+X, where G is government, I is investors, C X stands for an international business division, and C stands for consumers. The MPS for this economy is 0.6. Assume that the government increases its spending by $220 billion, and at the same time, the government implements a tax increase of the same amount ($220 billion) to pay for the cost of the additional spending. Also, assume that the tax increases causes C to fall by $140 billion. Will the economy grow if these changes are implemented? To answer this question, first calculate the multiplier. Then, take the multiplier into consideration to determine the overall (I.e., "net") effect of both raising taxes & increasing government spending by the same amount ($220 billion).

Explanation / Answer

Government spending multiplier (m1) = 1 / MPS = 1 / (1 - MPC) [Where MPS = 1 - MPC]

Tax multiplier (m2) = - MPC / (1 - MPC)

Overall multiplier, m = m1 + m2 = [1 / (1 - MPC)] - [MPC) / (1 - MPC)] = (1 - MPC) / (1 - MPC) = 1

So, as government spending increases and tax increases each by $220 billion, output increases by $220 billion. Therefore, economy will grow if these changes are implemented.

Note that the decrease in consumption of $140 billion is included within the change in GDP.

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