Question

Assuming that the MPC = .75 and that prices are constant, which of the following fiscal policies would eliminate a recessionary gap of $60 billion while maintaining a balanced budget?

Answer 1

Answer:

Increasing government spending by $60 billion while raising taxes $60 billion

Explanation:

If we do the multiplicator of Government spending which is equal to = 1/MPS

And MPS (marginal propensity to save) = 1 - MPC (marginal propensity to consume)

But MPC = 0.75

Hence multiplicator of Government spending  = 1/(1-0.75) = 4

If we look for the multiplicator of taxes = -MPC/MPS

But MPS = 1 - MPC

= -MPC/(1-MPC)

= -0.75/0.25 = -3

Hence if government spending is increased by $60 billion, GDP will be increased by 60 x 4 = $240 billion

Also if taxes are increased by the same amount, GDP will decrease by 60x3 = $180 billion

Hence this means that GDP will increase by 60 billion dollars, as the difference between the both is 240 - 180 = 60 billion dollars