Problem-Solving

Question

Assume an open, mixed economy. That is, foreign trade is part of the economy, and the economy includes both a public (government) and a private (consumers and businesses) sector. Given this, aggregate demand is expressed as (C + I + G + X). Assume the MPC is .7. Assume a stimulus package of $100 billion has been approved by Congress and the money has been spent. In order to pay for those expenditures, Congress also approved a $100 billion increase in individual income taxes. (This means Congress would not allow deficit spending in order to stimulate the economy.) Will these actions by Congress expand or contract the economy or are they just useless actions? 

Answer 1

Mafer,

If the MPC is .7 then the MPS is .3 and the multiplier is 1/.3 = 3.33

Fiscal Policy Expansionary - Gs = 100b x 3.33 = 3.33b increase in GDP

Fiscal Policy Contractionary - Tax inc = 100 x 2.33 (as the tax multiplier is 1 less) = 2.33 decrease in GDP

Net Effect of equal GS & Tax increase = GDP increases by 1.33b

C