Assume that a hypothetical economy with an MPC of 0.9 is experiencing severe rec

Question

Assume that a hypothetical economy with an MPC of 0.9 is experiencing severe recession.

Instructions: In part a, round your answers to 2 decimal places. Enter positive numbers. In part b, enter your answers as whole numbers.

a. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion?
Answer: $_________billion.

     How large a tax cut would be needed to achieve the same increase in aggregate demand?
Answer: $__________ billion.

b. Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

     Increase spending by $_________ billion.

     Increase taxes by $____________ billion.

Explanation / Answer

a. MPC = 0.9

So, the spending multiplier = 1/(1-mpc) = 1/ (1- 0.9) = 1/ 0.1 = 10

Thus, government spending have to rise by $25 / 10 = $2.5 billion

Again, the tax cut multiplier = mpc / (1-mpc) = 0.9/ (1 - 0.9) = 9

Therefore, to increase aggregate demand by $25 billion, a tax cut of (25/ 9)= $2.78 billion will be required.

b. $25 billion increase in government spending results in an increase in aggregate demand of $250 billion. (i.e. 10 (expenditure multiplier) x $25 billion).

To finance this government spending of $25 billion we raise taxes by an equivalent amount to ensure the level of outstanding debt does not change. So,$25 billion increase in tax results in a decrease in aggregate demand of $225 billion (i.e. 9 (tax multiplier) x $25 billion).

Thus, Combining the two effects above, we have an increase in aggregate demand of $25 billion (i.e. $250 (increase from government spending) - $225 (decrease from increase in taxes)). This increase is achieved without increasing the debt.

Thus, the final answer is:

Increase spending by $25 billion.

   Increase taxes by $25 billion.

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