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 sustain a full-employment, noninflationary GDP while increasing government spending by $21 billion, the government must offset this increase by reducing aggregate demand elsewhere in the economy. Since the marginal propensity to consume (MPC) is 0.75, every dollar of tax increase will reduce consumption by $0.75, leading to a smaller multiplier effect on aggregate demand. To fully offset the $21 billion increase in spending, the government needs to increase taxes by an amount that, after accounting for the multiplier effect, equals $21 billion. The formula to calculate the required tax increase is $\Delta T = \frac{\Delta G}{MPC}$, where $\Delta G$ is the change in government spending and $MPC$ is the marginal propensity to consume. Plugging in the values, we get $\Delta T = \frac{21}{0.75} = 28$. Therefore, the government must increase taxes by $28 billion to sustain full-employment, noninflationary GDP.

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