Question

THE GOVERNMENT HAS $100 MILLION TO SPEND ON THE ECONOMY, BUT IS UNCERTAIN IF TO DO: OUTRIGHT GOVERNMENT EXPENDITURES OR A TAS CUT; ASSUMING AN MPC = 0.75 AND A TAX RATE = 0.05, WHICH OPTION SHOULD THE GOVERNMENT SELECT THAT WILL MAXIMIZE IMPACT ON THE ECONOMY?

Answer 1

Government spending multiplier is greater than tax multiplier so in order to have a greater impact government should raise its spending.

Spending multiplier $= 1/(1 - MPC(1-t)) = 1/(1-0.75 \times 0.95) = 3.478$

Tax multiplier $= -MPC(1-t)/(1 - MPC(1-t)) = -0.7125/0.2875 = -2.478$

Hence rise in GDP with increase in $G = 100 \times 3.478 = 347.8$ billion

Rise in GDP with tax cut $= -100 \times -2.478 = 247.8$ billion