Suppose that a reduction in the tax rate were expected to increase the after- tax income of all citizens by a total of $10 billion. Suppose further that this money were to be transferred in one payment in April. We should expect
A) GDP to climb by less than $10 billion because the stimulus would certainly increase interest rates enough to dampen investment.
B) GDP to climb by more than $10 billion as long as interest rates did not climb too severely.
C) GDP to climb by exactly $10 billion if interest rates were to hold steady.
D) GDP to be unaffected, since most people would put such a lump sum windfall tax savings in the bank "for a rainy day."
E) none of the above.

Question

Quizplus · Accepted Answer

The multiplier effect suggests that an increase in spending leads to an increase in national income and consumption greater than the initial amount spent. Therefore, if citizens collectively receive a $10 billion increase in after-tax income and spend it, this initial spending will generate more than $10 billion in total economic activity, assuming interest rates do not rise significantly to dampen investment.

Suppose That a Reduction in the Tax Rate Were Expected