Question

Cazenovia is in the midst of a bad recession, and its Congress has placed economic recovery at the top of its political agenda. Different expansionary fiscal policies are currently being examined, but members of Congress are aware of the problems associated with large, sustained government deficits and will not accept any proposal that increases the deficit by more than $2 million. After lengthy discussions, these are the final proposals: Plan A: Spend $2 million on highways Plan B: Reduce taxes by $2 million Assume the economy of Cazenovia is characterized by the following four equations in the short run: C + / + G + NX Co + CylY-T) 1o (a constant) 0 + C NX

Answer 1

MPC = Marginal propensity to cpnsume = C_Y = 0.6  

$\Delta$G = 2 million

Govt. expenditure multiplier

$\Delta$Y/$\Delta$G = 1/(1- MPC)  

$\Delta$Y/$\Delta$G = 1/(1 - C_Y )

$\Delta$Y/2 = 1/(1 - 0.6)

$\Delta$Y/2 = 1/0.4

$\Delta$Y = 5

hence GDP will increse by $5 million