Question

4a. The government of Peru is facing an inflationary gap. Presume they plan a tax increase of $35 billion and spending decreases of $15 Billion. The MPC for the country is 0.55. We are curious what the fiscal impact will be from the policy. What would be the total decrease in GDP based on the fiscal multiplier using the data above? 4b. Let's use a more realistie multiplier - Let's add some realism to the exercise and include the effects of tax and import leakages on the multiplier. In Peru, taxes are 0.20 and imports are 0.25. What is the decrease in GDP when you include these values in your multiplier calculation?

Answer 1

Solution:

4a. The fiscal plan by Peru government is

Tax change = + $35 billion

Spending change = - $15 billion

MPC = 0.55

In this case, our equilibrium equation is

Y = C(bar) + MPC*(Y - T) + G + I + (X - M); where Y is real GDP, C(bar) is autonomous consumption spending

T is taxes

G is government spending

I is investment spending

X is exports and M is imports

Then, autonomous spending, say A(bar) = C(bar) - MPC*T + G(bar) + I(bar) + (X(bar) - M(bar)), basically sum of all terms independent of Y

And multiplier = 1/(1 - MPC) = 1/(1 - 0.55) = 2.222

So, change in autonomous spending = -MPC*(change in taxes) + change in government spending

= - 0.55*35 + (-15) = - $34.25 billion

Total change in GDP = multiplier*change in autonomous spending

Total change in GDP = 2.222*-34.25 = - $76.111 billion

So, total decrease in GDP with this fiscal multiplier would be of $76.11 billions.

4b. Now, the equilibrium rahati on becomes:

Y = C(bar) + MPC*(Y - t*Y) + G(bar) + I(bar) + (X(bar) - M);

Where t is tax rate, such that taxes = t*Y

And M is dependent on income through marginal propensity to import, m. So, M is function of m*Y

Rest is same as above

We are given t = 0.20 and m = 0.25

Then, in this case, the fiscal multiplier is

Multiplier = 1/[1 - MPC*(1 - t) + m]

Multiplier = 1/[1 - 0.55*(1 - 0.2) + 0.25] = 1/0.81 = 1.235

So, change in GDP = 1.235*-34.25 = - $42.284 b

So, now total decrease in GDP is $42.284 billions.