An economy is experiencing a high rate of inflation.The government wants to reduce consumption by $36 billion to reduce inflationary pressure.The MPC is 0.75.By how much should the government raise taxes to achieve its objective?

Question

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The government should raise taxes by $12 billion to achieve its objective. The formula for the change in equilibrium income is: ΔY = ΔG + ΔI + Δ(NX) + Δ(T-TR)where:ΔY = change in equilibrium incomeΔG = change in government spendingΔI = change in investmentΔ(NX) = change in net exportsΔ(T-TR) = change in taxes minus transfer paymentsIn this case, we know that the government wants to reduce consumption by $36 billion. We also know that the MPC is 0.75. This means that for every $1 decrease in consumption, equilibrium income will decrease by $0.75. Therefore, to reduce consumption by $36 billion, the government needs to reduce equilibrium income by $36 billion / 0.75 = $48 billion.To reduce equilibrium income by $48 billion, the government can either increase taxes or decrease spending. In this case, the government wants to raise taxes. Therefore, the government needs to raise taxes by $48 billion.

An Economy Is Experiencing a High Rate of Inflation