Assume that the federal government gives a $5 billion tax cut. Assume that tax rates are fixed, the economy is closed, and the marginal propensity to consume is 0.75. What happens to equilibrium GDP?

Question

Quizplus · Accepted Answer

The multiplier effect suggests that a change in autonomous spending (in this case, a tax cut) will have a larger impact on equilibrium GDP. Using the formula for the multiplier, we get: 
Multiplier = 1/(1-MPC) 
= 1/(1-0.75) 
= 4 
Therefore, the $5 billion tax cut will lead to a $20 billion increase in equilibrium GDP (4*$5 billion).

Assume That the Federal Government Gives a $5 Billion Tax