Assume an open, mixed economy. That is, foreign trade is part of the economy, an

Question

Assume an open, mixed economy. That is, foreign trade is part of the economy, and the economy includes both a public (government) and a private (consumers and businesses) sector. Given this, aggregate demand is expressed as (C + I + G + X). Assume the MPC is .7. Assume a stimulus package of $100 billion has been approved by Congress and the money has been spent. In order to pay for those expenditures, Congress also approved a $100 billion increase in individual income taxes. Will these actions by Congress expand or contract the economy or are they just useless actions?

Explanation / Answer

Given that mpc is 0.7, we know that for every dollar in income, 70 cents is spent, and 30 cents is saved. Since the go to is trying to stimulate the economy, hence, the gdp, by 100 billion, this amount will be synonymous to an increase in total income,y, by the same amount. But since mpc is 0.7, only 70 billion of this income will be spent. So, the net output is 170 billion. But, since this spend is tax financed, the government will have to tax income taxes to raise the equivalent amount of 100 billion. So, the total net effect is 170-100= 70 billion increase in total income, y, or gdp. The action is positive, it will expand the economy, but not as large as they think.

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