Question

Suppose that the average wage earner saves 14% of her take-home pay and spends the other 86%. Also suppose that 86% of any amount spent is always re-spent (with 14% saved). Estimate the impact that a proposed $30 billion tax cut will have on the economy over the long run due to the additional spending generated. (Round your answer to the nearest integer.)

Answer 1

Solution and Explanation:

A 30bn$ tax cut will mean that there is 35bn$ of added take home pay available to all the wage earners.

This would simply mean that 14% of 30bn $ = 4.2bn$ would be added to the national savings and the rest 86% of 35bn$ = 25.8bn$ would be additional spending. This would inturn generate 25.8bn$ of added income (since someone's expenditure is someone else's income);

So out of this 25.8bn$ 14% will be saved and 86% will be respent; and this chain will continue;

So total added consumption expenditure due to the 30bn $ tax cut = $30\left(0.86+0.86^{2}+0.86^{3}+\ldots\right)$

$=30^{*}(0.86) /(1-0.86)=184.285 \mathrm{bn}$ (Rounded off)

This is the total additional spending (consumption in an economy because of the stimulus provided by the tax cut of 30bn$);

The total impact on the economy over long run = 184bn$ of additional expenditure