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?
A) $6 billion
B) $9 billion
C) $12 billion
D) $16 billion

Question

Quizplus · Accepted Answer

To reduce consumption by $36 billion, we need to use the formula: 
∆Y = (∆C) / MPC 
Where, 
∆Y = change in income
∆C = change in consumption 
MPC = marginal propensity to consume

Given, 
∆C = -$36 billion 
MPC = 0.75 
Substituting these values in the formula, we get: 
∆Y = (-$36 billion) / 0.75 
∆Y = -$48 billion

This means that in order to reduce consumption by $36 billion, the government needs to reduce aggregate demand (Y) by $48 billion. Since taxes are a leakage in the circular flow of income, an increase in taxes (T) will reduce consumption and hence decrease aggregate demand.

Since the question asks by how much should the government raise taxes, we need to figure out the value of the multiplier (k) using the formula: 
k = 1 / (1 - MPC)

Substituting the value of MPC in this formula, we get: 
k = 1 / (1 - 0.75) 
k = 4

This means that for every $1 increase in taxes, aggregate demand will decrease by $4. Hence, to achieve a reduction of $48 billion in aggregate demand, the government needs to increase taxes by: 
∆T = (∆Y) / k 
∆T = (-$48 billion) / 4 
∆T = -$12 billion

Therefore, the government should raise taxes by $12 billion to achieve its objective of reducing consumption by $36 billion.

An Economy Is Experiencing a High Rate of Inﬂation