Suppose the economy is in a recession and that the marginal propensity to consume is 0.8. Assuming that the price level is constant, by how much would government have to decrease household taxes in order to increase real output by $200 billion?

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) is 0.8, which means for every dollar of income, consumption increases by 80 cents. To find out how much taxes need to be decreased to increase real output by $200 billion, we use the multiplier formula: 1/(1-MPC). Here, the multiplier is 1/(1-0.8) = 5. Therefore, to increase output by $200 billion, taxes need to be decreased by $200 billion / 5 = $40 billion. However, since the question asks for the increase in real output, and the decrease in taxes directly increases disposable income which then is multiplied through the economy, the correct calculation should consider how the initial increase in disposable income translates into a larger increase in real output due to the multiplier effect. Given the multiplier of 5, to achieve a $200 billion increase in real output, the initial increase in disposable income (or decrease in taxes) should be $200 billion / 5 = $40 billion. My initial explanation contained an error in interpreting the final step of the calculation. The correct answer is indeed to find the initial tax decrease required to achieve the desired increase in output, which, based on the multiplier effect, is $40 billion. This was a mistake in my explanation process. The correct calculation based on the given MPC and the desired increase in real output should lead to the conclusion that a smaller tax decrease is required to achieve the larger output increase due to the multiplier effect.

Suppose the Economy Is in a Recession and That the Marginal