Question

If real GDP is $500 billion, full employment GDP is $300 billion, and the marginal propensity to consume is 0.9, then Congress should:
1. increase taxes by exactly $20 billion.
2. increase taxes by $50 billion.
3. increase taxes by $22.22 billion.
4. decrease spending by $30 billion.
5. decrease spending by $50 billion.

Answer 1

Answer:

tax increased = $22.22 billion

so correct option is 3. increase taxes by $22.22 billion.

Explanation:

given data

real GDP = $500 billion

employment GDP = $300 billion

marginal propensity = 0.9

solution

we know here that Inflationary gap will be

Inflationary gap = Real GDP - Full-employment GDP

Inflationary gap = $(500 - 300) billion

Inflationary gap = $200 billion

and tax Multiplier is

Tax Multiplier  = $\frac{- marginal propensity}{1 - 0.9}$

Tax Multiplier  = -9

here negative sign means that decrease real GDP by $9

so tax should be increased by $1

so we can say that decrease real GDP by $200 billion

and  tax should be increased = $\frac{200 billion}{9}$  

tax increased = $22.22 billion

so correct option is 3. increase taxes by $22.22 billion.