An economy is experiencing a high rate of inflation.The government wants to reduce GDP by $36 billion to reduce inflationary pressure.The MPC is .75.By how much should the government raise taxes to achieve its objective?
A)$6 billion
B)$9 billion
C)$12 billion
D)$16 billion

Question

Quizplus · Accepted Answer

To calculate the required change in taxes, we can use the formula:
Change in GDP = - MPC x Change in Taxes
We know the required change in GDP (-$36 billion) and the MPC (0.75). Substituting these values in the formula, we get:
-$36 billion = -0.75 x Change in Taxes
Solving for Change in Taxes, we get:
Change in Taxes = ($36 billion) / (0.75) = $48 billion
Since the government wants to reduce GDP by $36 billion, it will need to reduce aggregate demand (AD) by this amount. One way to do this is by raising taxes, which will reduce disposable income and therefore consumption spending. To achieve a reduction in AD of $36 billion, the government will need to raise taxes by $48 billion (which is equal to the change in taxes calculated above). However, the question asks for how much the government should raise taxes to achieve a reduction in GDP of $36 billion. Since the MPC is 0.75, we know that a $48 billion change in taxes will lead to a change in GDP that is 0.75 times as large, or $36 billion:
Change in GDP = MPC x Change in Taxes
Change in GDP = 0.75 x $48 billion
Change in GDP = $36 billion
Therefore, the government should raise taxes by $12 billion (which is 0.25 times the $48 billion change in taxes needed to reduce AD by $36 billion) to achieve its objective of reducing GDP by $36 billion.

An Economy Is Experiencing a High Rate of Inflation