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. By how much would government spending have to rise to shift the aggregate demand curve rightward by $40 billion? $ billion. How largo a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

Explanation / Answer

A.

MPC = .9

Thus,

Multiplier = 1/ (1-MPC) = 1/(1-.9) = 1/.1 = 10

Thus, to increase the aggregate demand by $40 Billion,

Increase in Government spending = 40 / multiplier = 40/10

Increase in Government spending = $4 Billion

Tax multiplier = MPC*(1/(1-MPC) = .9*10 = 9

Thus,

Size of the tax cut = 40/9

Size of the tax cut = $4.45 Billion

B.

Let,

Increase in government spending = G

Increase in Tax = T

Then,

(G - .9T)*M = 40 -----------------(1)

If Government spending = $8 Billion

(8 – 4)/.9 = T

T = increase in taxes = $4.44 Billion

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