Calculate the aggregate demand if: Government taxation and spending are zero. Pl

Question

Calculate the aggregate demand if: Government taxation and spending are zero. Planned investment is $300 billion. Net imports $50 billion. The marginal propensity to spend is 0.7. The autonomous consumer expenditure is $50 billion. Explain in words, what will happen to the aggregate demand according to the IS model, if the government imposes income or salary taxes amounting to $100 billion but spends all of that money on education, health and public transport. Provide your reasoning in full and apply it to part a) of this question deriving the new aggregate demand.

Explanation / Answer

(i) Aggregate demand:

Y = Consumption (C) + Planned investment (I) + Government spending (G) + Export - Import

C = Autonomous consumption + MPC x Y

C = 50 + 0.7Y

So,

Y = 50 + 0.7Y + 300 + 0 + 0 - 50

(1 - 0.7)Y = 300

0.3Y = 300

Y = 1,000 ($ Billion)

(ii) Imposition of tax will reduce disposable income, which will lower consumption demand. So, aggregate demand falls. However, increased government spending will increase aggregate demand. Since Spending multiplier is higher than Tax multiplier, an equal rise in both tax and government spending will result in a net increase in aggregate demand.

With Tax,

C = 50 + 0.7 x (Y - T) = 50 + 0.7 x (Y - 100) = 50 + 0.7Y - 70

C = 0.7Y - 20

Y = C + I + G - M

Y = 0.7Y - 20 + 300 + 100 - 50

(1 - 0.7)Y = 330

0.3Y = 330

Y = 1,100 ($ Billion)

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