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Fiscal effect of an increase in taxes

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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.

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Solution Preview

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 ...

Solution Summary

This solution gives detailed calculations showing how to determine the total effect on Aggregate Demand of a tax increase.