A government is currently operating with an annual budget deficit of $40 billion. The government has determined that:
--The marginal propensity to consume is 0.75.
--To eliminate an inflationary gap and take into account the resulting change in the price level, the government must generate a net leftward shift in the aggregate demand curve equal to $40 billion.
Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? Explain by giving appropriate reasons.
If MPC is 0.75, then the economy's Spending Multiplier (SM) is 1/(1-MPC) = 1/0.25 = 4
The Tax Multiplier (TM) = 1 ...
This solution gives detailed calculations showing how to determine the total effect on Aggregate Demand of a tax increase.