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QUESTION 12 In the aggregate expenditure model if the government of Pasedonia decides to increase government spending by $ 100 billion and to finance this increase in government spending the government of Pasedonia increases taxes by $ 100 billion what effect will this have on the economy? (assume MPC 0.75) O A GDP stays the same B. GDP increases by $ 100 billion OC. GDP will increase by $ 400 billion OD. GDP will decrease QUESTION 13 An example of an automatic stabilizer is: o the President and Congress agree to new legislation that will cut taxes during a recession OB. the drop in income taxes that occurs during recessions from the general drop in incomes the President and Congress agree to new legislation that will increase government spending during a recession D. All of the above

Answer 1

12) Consumption function is: C = a + b(Y - T)

Now if taxes are increased by $100, it implies that consumption will be lowered by: b $\times$ reduction in tax = 0.75 $\times$ 100 = 75 Now since the govt exp has increased by 100, the difference comes out to be 100 - 75 = 25. Thus the net income has increased by 25 $\times$ multiplier of the economy. Multiplier is given by 1 / 1 - b = 1 / 1 - 0.75 = 4

Thus the income will increase by 4 $\times$ 25 = $100 (b)

13) Automatic Stablilizers refer to such policy measures which dampen the fluctuations in the economy during recessions and boom periods. All of the above measures are an example of automatic stabilizer. The correct answer is (d).

14) To close an inflationary gap, the government must increase taxes and reduce its expenditure. So, the answer would be (c) because this would lead to a reduced economic activity and thus lesser inflationary gap.

15) If a country has a cyclically adjusted budget deficit it means the govt expenditure is less than tax revenue is the wrong statement (d). Cyclically adjusted budget deficit adjusts for the cyclical fluctuations of the business cycle in an economy.