CHAPTER 11

 

MANAGING AGGREGATE DEMAND: FISCAL POLICY

 

TEST YOURSELF

 

2.

                      GDP      Taxes    Disposable Income       Consumption    Total Expenditure

                       1,360       320               1,040                           810                     1,540

                       1,480       360               1,120                           870                     1,600

                       1,600       400               1,200                           930                     1,660

                       1,720       440               1,280                           990                     1,720

                       1,840       480               1,360                        1,050                     1,780

 

Compared to Question 1, the expenditure line has a flatter slope, but it still crosses the 45-degree line at a GDP of 1720. The marginal propensity to consume is still 0.75. Now, however, the marginal tax rate is 1/3 (that is, when income rises by 3, taxes rise by 1). Consequently the multiplier falls to 2. A reduction in G of 60 will lower equilibrium GDP by 120 (provided prices do not change), to a new level of 1600. Comparison of the two questions shows that the introduction of a variable tax lowers the multiplier.

 

 

DISCUSSION QUESTIONS 

1.   (a) If the decreases in government is not accompanied by cuts in taxes, then this decrease in government spending will lead to a smaller budget deficit. As a result GDP would decrease because while government spending has decreased by a specific amount, consumption has only increased by that amount multiplied by MPC.

 (b) If government spending is switched toward other purchases, total G will not change, and GDP will not be affected.

2.   An increase in autonomous spending, whether consumption, investment or government spending, increases GDP in the initial round by exactly the amount of the increase in spending: there is no difference between C, I and G in this respect. A tax reduction, however, does not initially increase GDP, but only disposable income. The initial increase in GDP is less than this; it is equal to the reduction in taxes (increase in disposable income) times the marginal propensity to consume. Note also the minus sign: GDP moves in the opposite direction from the tax change.

3.   To reduce aggregate demand, the government can reduce its spending on goods and services, raise taxes or reduce transfer payments. To increase aggregate demand, it can do the opposite: increase government spending, reduce taxes or increase transfer payments.

 

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