Question

Question 4 In a simple Keynesian model, assume that the marginal propensity to consume (MPC) is 0.5. a) Find the government purchases multiplier b) Find the tax multiplier c) If the government wants to increase equilibrium real GDP by $ 500 billion, how much should the government increase spending? d) For the same purpose, how much should the government decrease taxes? According to Ricardian equivalence, do you think the government estimate is correct (should the government decrease taxes or not)? Why or why not? e) Use your answers from a) and b): If government purchases are increased by $20 billion and at the same time taxes are increased by $20 billion (taxes are increased to finance the government expenditure), find changes in GDP and the balanced budget multiplier (the net effect).

please show solutions also. Thanks

Answer 1

A. Govt expenditure multiplier=1/1-Mpc=1/1-0.5=2

b. Tax multiplier = -Mpc/1-mpc=-0.5/1-0.50= -1

c. In order to change equilibrium level of income by 500, govt expenditure must increase by 250billion

d. In order to increase income by 500billion, taxes need to decrease by 500billion

e. Government balance budget multiplier=1

when govt. expenditure and taxes both increases by 20billion then the equilibrium level of GDP increases by 20billion because Balance budget multiplier=1