possible combination of government spending increases and tax decreases

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Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion?

How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference?

Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal.

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Solution Preview

Expenditure multiplier is given as 1/(1 - MPC). Tax multiplier is given by MPC/(1 - MPC).

a. Given that MPC is 0.8, the expenditure multiplier is 1/(1 - 0.8) = 1/0.2 = 5. To obtain a shift in AD of $25 billion we would need an expenditure change that is one-fifth this amount (since the multiplier is 5), and thus government has to increase spending by 25/5 = $5 ...

Solution Summary

This solution determines one possible combination of government spending increases and tax decreases that would accomplish this same goal.

$2.49