Question

A government is currently operating with an annual budget deficit of $40 billion. The government has determined that:
• Every $10 billion reduction in the amount of bonds it issues each year would reduce the market interest rate by 0.1 percentage point.
• Every 0.1 percentage point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to $5 billion. The marginal propensity to consume is 0.75.
• To eliminate an inflationary gap and take into account the resulting change in the price level, the government must generate a net leftward shift in the aggregate demand curve equal to $40 billion.
Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? Explain by giving appropriate reasons.

Answer 1

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