Question

Which has a larger effect on aggregate demand: an increase in government expenditure or an equal sized decrease in taxes? 4.

Answer 1

Answer 4

Equilibrium occurs when Y = AE and AE = C + I + G + NX

where Y = Aggregate output, AE = Aggregate expenditure.

where C = Co + c(Y - T) , I = Investment, G = Government spending, NX = Net exports, C = Consumption, Co = Autonomous consumption, c = Marginal Propensity to consume(MPC) and also we have 0 < c < 1, T = Taxes.

In a simple model, Lets assume I , G and NX to be autonomous(i.e. independent of Y).

Thus, Y = AE => Y = C = Co + c(Y - T) + I + G + NX

=> Y - cY = Co - cT + I + G + NX

=> Y = [1/(1 - c)](Co - cT + I + G + NX)

=> Y = -(cT/(1 - c)) + G/(1 - c) +[1/(1 - c)](Co + I + NX)

All else constant If we decrease Tax(T) by 1 unit then Y will increase by c/(1 - c) unit.

All else constant If we increase Government spending(G) by 1 unit then Y will increase by 1/(1 - c) unit.

As c < 1 because Marginal propensity to consume is lesser than 1. Thus 1/(1 - c) > c/(1 - c). Hence, increase in government expenditure has larger effect on Real Aggregate output than equal decrease in Taxes.

As Aggregate demand curve shows combination of Y and Price level(P) where economy is in equilibrium. As, increase in government expenditure has larger effect on equilibrium Real Aggregate output than equal decrease in Taxes.

Hence, An increase in government expenditure has a larger effect on Aggregate Demand than equal decrease in taxes.