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Chapter 21: Q 22. (page 567)

If the marginal propensity to consume is 0.75, by how much would government spending have to rise to increase output by \(1,000 billion? By how much would taxes need to decrease to increase output by \)1,000 billion?

Short Answer

Expert verified

Government spending would need to increase, or taxes would have to fall by $250 billion

Step by step solution

01

Multiplier Concept 

It states that increase in income is many times the change in autonomous variables, like increase in government expenditure or decrease in taxes.

Formula = Change in Income

Change (rise) in government expenditure, or fall in taxes

02

Numerical Solution 

Multiplier = 1 / (1 - MPC)

  • As MPC = 0.75

Multiplier 'k' = 1 / (1-0.75)

= 1 / 0.25

k = 4

  • As change in income needed = 1000

Let change in investment or tax be = x

4 = 1000 / x

x = 1000 / 4

x, ie Change in Investment or tax needed = 250

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Most popular questions from this chapter

Consider an economy described by the following data:

C=\(3.25trillionI=\)1.3trillionG=\(3.5trillionT=\)3.0trillionNX=-\(1.0trillionf=1

mpc = 0.75

d = 0.3

x = 0.1

a. Derive simplified expressions for the consumption function, the investment function, and the net export function.

b. Derive an expression for the IS curve.

c. If the real interest rate is r = 2, what is equilibrium output? If r = 5, what is equilibrium output?

d. Draw a graph of the IS curve showing the answers from part (c) above.

e. If government purchases increase to \)4.2 trillion, what will happen to equilibrium output at r = 2? What will happen to equilibrium output at r = 5? Show the effect of the increase in government purchases in your graph from part (d).

Calculate the value of the consumption function at each level of income in the following table if autonomous consumption = 300, taxes = 200, and mpc = 0.9.

During and in the aftermath of the financial crisis of 2007鈥�2009, planned investment fell substantially despite significant decreases in the real interest rate.

What factors related to the planned investment function could explain this?

Go to http://www.eurmacro.unisg.ch/Tutor/islm.html. Set the policy instruments to G = 80, t = 0.20, c = 0.75, and b = 40. Now increase government spending, G, from 80 to 160. By how much does the IS curve shift horizontally to the right? Why is the amount of shift greater than the increase in G? Now increase the marginal propensity to consume, c, from 0.75 to 0.90. In which direction does the IS curve shift, and why? By how much does it shift? Now increase the tax rate, t, from 0.20 to 0.28. In which direction does the IS curve shift, and why? By how much does it shift?

Why do increases in the real interest rate lead to decreases in net exports, and vice versa?
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