If gov spending stays the same and there is a rise in the taxes placed by gov on

Question

If gov spending stays the same and there is a rise in the taxes placed by gov on the people, what'll happen?

Suppose for example the tax is of $100 million and the MPC is 0.6

I know that since
T = G + Sg
Sg should rise by $100 million. And since
Sp + Sb + Sg = Ig (domestic investment)
a rise in Sg of $100 million means a rise in Ig of $100 million.

And since Ig is part of AD, this means $100 million enters the multiplier, which is 2.5 here, so the rise in Sg should cause Y to rise by $250 million. Then we look at the fact that consumers would have spent $60 million of that tax, so since 60 * 2.5 = 150, we get a final answer that Y only rises by $100 million.

So what's my question? About the first part - how can the rise in Sg cause Y to rise by $250 million – that makes no sense. Remember, in my example, I said that the rise in Sg is NOT spent by the gov. So why should it enter the multiplier? (that would mean that the final answer cited above should be that Y falls by 150 million.) Yet if you say that the $100 million does not enter the multiplier, how can that be – I is comprised of Sp, Sb, and Sg, so if Sg rose, I has to rise, which means that AD has to rise.

I'm confused. Please help. Thank you

Explanation / Answer

If taxes increase, there will be a rise in governmnet revenue.
But the disposable income of the people will be decreasing. This decreases consumption as well as investment.
As u said, saving of private and government equal to total domestic investment is correct, but u have missed an important point, that for a closed economy, if all the saving is assumed to be invested than Savings=Domestic Investment.
let us assume that if you have $100, and personal consumption is $60, $40 is saving. The only amount left for u to invest in capital investments is $40, if u choose to invest every penny of saving, than I=$40.

Sasving and investment are interchangebly used, income minus consumption is saving. Saving is an investment for future consumption. It may or may not give returns.Let us say, the money in kiddy account is also an investment for future consumption. The part of saving which is invested in capital is considered as I in GDP caliculation.

Investment depends on MPI (marginal propencity to invest): it is cahnge in investment with a change in income.

I in GDP is private investment only.

Regarding government spending: Government increased taxes, this has increased its revenue. Its spending remained constant. The reserves in government has certainly increased, but government invetsments are constant as G is constant.

Government spends on products and capital goods.

Spending on capital goods is invetsmnt from the angle of government, but this is included in G.

In the above discussed case, government increased taxes, as a contractionary measure, which decreases the disposable income, reducing consumption as well as investment.

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.