Question

Suppose the gdp is in equilibrium at full employment and the mpc is .80. if government wants to increase its purchase of goods and services by $16 billion without changing equilibrium gdp, taxes should be

Answer 1

The marginal propensity to consume is a metric that quantifies the concept of increase in consumption with an increase in income. Mathematically MPC is defined as:

MPC = Change in consumption / Change in income

Purchase of goods and services is considered as consumption, therefore:

Change in consumption = $16 billion

In the government’s perspective, taxes are considered as income, therefore the problem ask us to find for the necessary change in tax collection to maintain equilibrium GDP. Substituting the values in the formula:

0.80 = $16 billion / Change in income

Change in income = $20 billion

Therefore the government should increase the tax collection by $20 billion.

Answer 2

The government should increase taxes by $20 billion in order to maintain the same equilibrium GDP.

Further Explanation:

Marginal propensity to consume (MPC): It can be defined as the degree of responsiveness of the consumption of the services and goods to the change in the level of income. It can be calculated as follows:

$\text{MPC}=\dfrac{\text{Change in consumption}}{\text{Change in income}}$

Three types of marginal propensity to consume are as follows:

• MPC greater than 1: It refers to changes in levels of income that lead to proportionately large changes in the level of consumption of a service or good.

• MPC equal to 1: It refers to changes in levels of income that lead to proportionately changes in the level of consumption of a service or good.

• MPC less than 1: It refers to changes in levels of income that lead to proportionately small changes in the level of consumption of a service or good.

Calculate the taxes collected by the government in order to maintain the same equilibrium GDP:

$\begin{aligned}\text{MPC}&=\dfrac{\text{Change in the consumption}}{\text{Change in the income}}\\0.80&=\dfrac{\text{\ 16 billion}}{\text{Change in the income}}\\\text{Change in the income}&=\dfrac{\text{\ 16 billion}}{0.8}\\&={\text{\ 20 billion}}\end{aligned}$

Therefore, the government should increase the taxes by $20 billion to maintain the same equilibrium GDP.

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Answer details:

Grade: High School

Subject: Economics

Chapter: Consumer Equilibrium

Keywords: Marginal propensity to consume, equilibrium, GDP, Purchase of goods and services, taxes, consumer equilibrium, gross domestic production.