Suppose the government reduces taxes by $20 billion, that there is no crowding o

Question

Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is 3/4.
a) What is the initial effect of the tax reduction on aggregate demand?
b) What additional effects follows this initial effect? What is the total effect of the tax cut on aggregate demand?
c) How does the total effect of this tax cut compare to the total effect of a 20 billion increase in government purchases? Why?
d) Based on your answer in part c), can you think of a way in which the government can increase aggregate demand without changing the government's budget deficit?

Explanation / Answer

The initial effect of the tax reduction of $20 billion on aggregate demand is $15 billion. [ A tax reduction of 20bln is already earned disposable income of the households and others. Of this additional income, they consume only 3'4ths as the mpc is 3/4. And 3/4th of $20 billion is $15 billion.] (b.) The additional effects that follow this initial effect is $45 billion. [This happens because after the initial increase in aggregate demand and therefore in aggregate income by $15 billion, in the next round there is further addition to aggregate demand by 3/4 of $15 billion or $10.25. billion. In the same way the next successive rounds the increases in aggregate demand are 3/4th of 10.25, 3/4th of 3/4 of 10.25, and so on.] The total effect of the tax cut on aggregate demand is the reduction in the tax amount multiplied by the tax multiplier = {(-$20 billion )* (-3/4)/ (1-3/4)} = $ (20* 3/4)/ 1/4 = $ 60 billion. (c.) The total effect of a $20 billion increase in government purchases would be higher because the initial effect is higher. A $20 billion govt. purchase is a straight addition to aggregate demand and initial round income expansion, unlike in the case of $20 billion tax cut, the taxpayers increased their consumoption demand by only $15 billion , mpc beimg 3/4. The total effect of govt purchases is given by the increase in govt. purchase of $20 billion multiplied by the spending multiplier. The spending multiplier is given by 1/ (1-moc) = 1/ (1-3/4) = 1/(1.4) = 4. So the total effect of the govt. purchase addition of $20 billion is $(20 *4) billion = $80 billion.. Thus, the total effect of this $20 billion tax cut is $20 billin lower than the the total effect of a $20 billion increase in government purchases. d) They can increase aggregate demand through open market operations by buying government bonds or lowering the reserve requirement ratio. Visit sources below for better appreciation, if required. Source(s): http://en.wikipedia.org/wiki/Multiplier_… http://www.unc.edu/depts/econ/byrns_web/…

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

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