During a recession, analysts at the CBO project that the economy is operating $1.5 trillion below potential output. Assuming the MPC is 0.8, by how much would the government have to cut taxes to restore potential output?
A) $375 billion
B) $300 billion
C) $1.2 trillion
D) $800 billion

Question

Quizplus · Accepted Answer

To restore potential output, the government needs to implement a fiscal stimulus that fills the gap of $1.5 trillion. With an MPC (marginal propensity to consume) of 0.8, the fiscal multiplier is 1/(1-MPC) = 1/(1-0.8) = 5. Therefore, the required tax cut is $1.5 trillion / 5 = $300 billion. However, the correct calculation should be to find the initial increase in spending needed to reach the full multiplier effect. Since the multiplier is 5, and we need to cover a $1.5 trillion gap, we divide the gap by the multiplier: $1.5 trillion / 5 = $300 billion. The mistake in my explanation was in the interpretation of the question's requirement for the direct answer, which should be about the size of the tax cut needed, not the calculation of the multiplier effect itself. The correct tax cut needed to achieve the desired increase in aggregate demand, considering the multiplier effect, is indeed $300 billion, but due to a misunderstanding in the explanation process, the focus was misplaced.

During a Recession, Analysts at the CBO Project That the Economy