Question

The topic: Assume an open, mixed economy.That is, foreign trade is part of the economy and the economy includes both a public (government) and a private (consumers and businesses) sector. Given this, aggregate demand is expressed as (C+I+G+ X). Assume the MPC is .7. Assume a stimulus package of $100 billion has been approved by Congress and the money has been spent. In order to pay for those expenditures, Congress also approved a $100 billion increase in individual income taxes. (This means Congress would not allow deficit spending in order to stimulate the economy.) Will these actions by Congress expand or contract the economy or are they just useless actions? Get started early and work with your class members to solve this problem. Note: Go back to the Policy Example using North Carolina as an example in Chapter 6 in your text. This is sort of the opposite scenario for the state of North Carolina. Can you see that?

Answer 1

The cycles such as boom and recession are part of the economy and in the situation of the free-market, they can not be avoided. However, the government can shorten such cycles or smoothen the effect through its policies. The government which has authority on the setting up of the fiscal policy can utilize it for such a scenario.
The government can increase its expenditure or can cut taxes or can use both to stimulate the aggregate demand in the economy. The effect of such action depends upon the marginal propensity of consume in the economy as it creates a multiplier effect in the economy. The effect of tax cuts tends to be lower than the increase in government expenditure in the economy.

Government expenditure multiplier = 1 / ( 1 − MPC ) or 1 / MPS
Tax multiplier = ( −MPC ) / ( 1 − MPC )

The government has increased tax expenditure by $100 billion but also raised the tax by $100 billion and MPC is 0.7

100 * 1 / ( 1 - 0.7 ) = 100 * ( 1 / 0.3 )
= 333.33 billion USD
There will be an increase of $333.33 billion USD in aggregate demand because of $100 billion rise in government expenditure.

100 * ( -0.7 ) / ( 1 - 0.7 )
= 100 * ( -0.7 / 0.3 )
= -233.33
There will be a decrease in aggregate demand by $233.33 billion because of $100 billion tax increase.

333.33 - 233.33 = $100 billion

The net effect will be a rise in aggregate demand by $100 billion without increasing the deficit.