Suppose that the economy has an expansionary gap of $1,000 and the MPC equals 0.8.With an upward-sloping short-run aggregate supply curve, by what amount will the government increase autonomous net taxes in order to close the gap?

Question

Quizplus · Accepted Answer

The MPC of 0.8 means that for every $1 increase in autonomous net taxes, consumption will decrease by $0.80. To close the expansionary gap of $1,000, the government needs to decrease aggregate demand by $1,000. Since autonomous net taxes are part of government spending, increasing taxes would decrease aggregate demand. To decrease aggregate demand by $1,000, the government needs to increase autonomous net taxes by $1,000/0.8 = $1,250. However, the question asks for the amount by which the government needs to increase autonomous net taxes to close the gap, not to decrease aggregate demand by the full amount. Therefore, the correct answer is $1,000/0.8 = $250. The other choices are incorrect because they are either too low or do not reflect the effect of the MPC.

Suppose That the Economy Has an Expansionary Gap of $1,000