If the MPC is 0.8, the net income tax rate is greater than zero, the marginal propensity to import is greater than zero and the government increases spending by $100 million, then we would expect the result, in the short-run, to be:

Question

Quizplus · Accepted Answer

Given an MPC (marginal propensity to consume) of 0.8, an increase in government spending will indeed increase real GDP due to the multiplier effect. However, because the net income tax rate and the marginal propensity to import are both greater than zero, these factors will dampen the multiplier effect. The presence of taxes reduces disposable income, thus reducing the amount consumers can spend out of each additional dollar of income. Similarly, when the marginal propensity to import is greater than zero, some of the spending leaks out of the domestic economy into imports, which does not contribute to domestic GDP. Therefore, while the increase in government spending will lead to an increase in equilibrium real GDP, it will be less than the $500 million increase that would occur with an MPC of 0.8 in a closed economy with no taxes.

If the MPC Is 0