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The Math Behind Fiscal Policy

1. Suppose the government decides to increase taxes by $30 billion in order to increase Social
Security benefits by the same amount. How will this combined tax-transfer policy affect Aggregate Demand (AD) at current prices?

2.If the AD shortfall is $800 billion and the Marginal Propensity to Consume (MPC) is 0.8,
(a) How large is the desired fiscal stimulus?
(b) How large an income tax cut is needed?
(c) Alternatively, how much more government spending would achieve the target?

3. If the AD excess is $400 billion and the MPC is 0.9,
(a) How much fiscal restraint is desired?
(b) By how much do income taxes have to be increased to get that restraint?

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Solution Preview

The government is simultaneously increasing taxes and increasing spending. The decrease in AD resulting from the increase in taxes will be offset by the increase in AD resulting from the increase in spending. If the Marginal Propensity to Consume (MPC) is constant among all consumers, we can expect AD to rise because the Spending Multiplier (SM) ...

Solution Summary

Shows how the government uses multipliers to calculate how much to increase spending or cut taxes in order to stimulate the economy.