If government purchases are increased by $100, taxes are reduced by $100, and the MPC is 0.8, equilibrium output will change by

Question

Quizplus · Accepted Answer

When government purchases are increased by $100, it directly increases aggregate demand and thus equilibrium output by $100. With a marginal propensity to consume (MPC) of 0.8, the multiplier effect is 1/(1-MPC) = 1/(1-0.8) = 5. Therefore, the initial $100 increase in government spending results in a total increase in equilibrium output of $100 * 5 = $500. Similarly, reducing taxes by $100 increases disposable income, leading to an increase in consumption. Since the MPC is 0.8, this translates to an $80 increase in consumption initially. Applying the multiplier, the total increase in equilibrium output from the tax cut is $80 * 5 = $400. Adding both effects together, the total change in equilibrium output is $500 (from increased government spending) + $400 (from the tax cut) = $900.

If Government Purchases Are Increased by $100, Taxes Are Reduced