Suppose that the government cuts net taxes by $10 billion. These are lump sum ta

Question

Suppose that the government cuts net taxes by $10 billion. These are lump sum taxes. To keep its budget balanced at its current level, it also reduces its spending by $10 billion. Which of the following summarizes the impact of the government's policy action on equilibrium output?



A. GDP goes up by less than $10 billion.

B. GDP goes up by more than $10 billion.

C. We can't say what will happen to GDP without knowing the numerical value of the MPC.

D. GDP falls by $10 billion.

E. GDP stays the same.

F. GDP goes up by $10 billion.

G. GDP falls by less than $10 billion.

H. GDP falls by more than $10 billion.

Explanation / Answer

Reduced government purchases will decrease GDP by the dollar amount of the reduction, in this case $10 billion. At the same time, reduced taxes will increase consumption spending, which will increase GDP. This increased consumption will not be equal to the decreased government spending, however, because of the MPC: some of the tax cuts will be spent, some will be saved. Only the amount spent will go back into GDP. While we do not know what the numerical value of the MPC is, it surely is somewhere between 0 and 1 (by definition it must not be less than 0 or more than 1), which means that GDP will fall by something less than $10 billion. The only way it GDP could stay the same would be if MPC = 1, which is not a realistic outcome for a tax decrease.

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