Question

a)     A simple closed economy with an mpc equal to 0.5. Investment spending has suddenly fallen, reducing aggregate demand and output to a level that is 100 million below Y*.

                   i.           If the government decide to try to get the economy back to full employment using only an increase in government spending, by how much would G need to be increased?

                 ii.           If the government, instead, decided to try to get the economy to full employment using only a lump-sum tax cut how big of a tax cut would be needed?

      

Answer 1

(i)

$Multiplier=\frac{1}{1-0.5}$

$∆Y=mult\times∆G$

$100 million=2\times∆G$

$∆G=50million$

The government will have to increase spending by 50 million.

(ii)

Tax multiplier, -mpc (mult)

$∆Y=-mpc(mult)\times∆T$

$∆Y=-0.5\times2×∆T$

$∆T=\frac{100million}{-1}$

$∆T=-100 million$

The government will have to give a lump-sum tax cut of 100 million.