Question

QULLIP A government is currently operating with an annual budget deficit of $40 billion. The movernment has determined that every $10 billion reduction in the amount of bonds it issues each year would reduce the market interest rate by 0.10 percentage point. Furthermore, it has determined that every 0.10 (one-fenth) percentage point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to $4 billion. The marginal propensity to consume is 0.75. Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price level, it must generate a net leftward shift in the aggregate demand curve equal to 560 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? 5 billion (Enter your response rounded to two decimal places) Hint: How much new private investment spending is induced by each 10 billion decrease in government spending?

Answer 1

In the question marginal propensity to consume is given 0.75, which means with the every change in income we will have .75 change in consumption. If we increase the income level by $1 that will lead to increase in demand with $0.75

dC/dY = MPC where dC= change in consumption (demand) dY= change in Income

here Govt need decrease in demand by $ 60 billion with MPC of .75

60/dY = 0.75

dY= 60/0.75

dY= 80

The answer to the question is $ 80 billion is the amount of tax Govt should impose to reduce the demand by $ 60 billion.