If government spending is increased by $300, taxes are reduced by $300, and the MPS is 0.5, equilibrium output will change by

Question

Quizplus · Accepted Answer

The multiplier effect in this scenario is 1/(1 - MPS) = 1/(1 - 0.5) = 2. An increase in government spending of $300 and a decrease in taxes by $300 both stimulate the economy. The total initial injection into the economy is $600 ($300 from spending and $300 from tax cuts). With a multiplier of 2, the total change in equilibrium output is 2 * $600 = $1200. However, the tax cut's effect must be adjusted for the marginal propensity to save (MPS). Since only half (MPS = 0.5) of the tax cut is spent, the effective injection from the tax cut is $150, making the corrected total initial injection $450 ($300 from spending + $150 from tax cut). Thus, the total change in equilibrium output is 2 * $450 = $900.

If Government Spending Is Increased by $300, Taxes Are Reduced