Suppose the economy is operating at its full-employment, noninflationary GDP and the MPC is 0.75.The federal government now finds that it must increase spending on military goods by $21 billion in response to deterioration in the international political situation.To sustain full-employment, noninflationary GDP, government must
A)reduce taxes by $28 billion.
B)reduce transfer payments by $21 billion.
C)increase taxes by $21 billion.
D)increase taxes by $28 billion.

Question

Quizplus · Accepted Answer

To offset the increase in government spending and maintain full-employment GDP, taxes should be increased by the amount of the spending multiplied by the spending multiplier. The spending multiplier is 1/(1-MPC) = 4. Therefore, $21 billion * 4 = $84 billion in total impact, requiring a tax increase of $28 billion (since the tax multiplier is MPC/(1-MPC) = 3).

Suppose the Economy Is Operating at Its Full-Employment, Noninflationary GDP