Suppose the government is mandated by law to have a balanced budget. The marginal propensity to consume is 0.9. The government raises both taxes and spending by $10 billion. According to the notion of the balanced budget multiplier
A) income falls by $10 billion, because taxes reduce spending by $100 billion and government spending raises total spending by $90 billion.
B) income rises by $10 billion, because taxes reduce spending by $90 billion and government spending raises total spending by $100 billion.
C) there is no effect on the economy, because the tax and spending increases cancel each other out.
D) income rises by $.9 billion, because taxes reduce spending by $8.1 billion and government spending raises total spending by $9 billion.

Question

Quizplus · Accepted Answer

The balanced budget multiplier suggests that if the government increases taxes and spending by the same amount, total income will increase by that amount. This is because the multiplier effect of government spending is larger than the reduction in consumption due to the tax increase, given the marginal propensity to consume is less than 1.

Suppose the Government Is Mandated by Law to Have a Balanced