Question

Suppose that the consumption function is C = 14 + 0.8Yd, the investment is fixed at 12, and the government spending is equal to 10. Yd denotes the aggregate disposable income. The tax imposed is also equal to 10 and fixed.

(1) Solve the equilibrium GDP.

(2) How large is the fiscal multiplier, ∆Y/∆G?

(3) Explain economically why the fiscal multiplier is greater than 1.

Suppose next that taxes are imposed proportionally to the aggregate income, Y , with a rate equal to 10%.

(4) Solve the equilibrium GDP.

(5) How large is the fiscal multiplier, ∆Y/∆G, under the proportional income tax?

(6) Give an economic explanation about why the fiscal multiplier under a proportional income tax is smaller than when the tax revenue is fixed.

Answer 1

1. The economy can be represented by the following equation:

2. The fiscal multiplier is the change in output for a unit change in government spending:

3. The multiplier effect is the increase in the economy's output level when government spending increases by one unit. This is generally greater than one because the marginal propensity to consume is always greater than zero. For every extra dollar the government spends, the households increase their consumption expenditure which leads to a greater increase in the economy's output level.

4. The new tax is dependent on the aggregate income and is