Suppose the federal government imposes a $10 billion tax increase.Assume that taxes are fixed, the economy is closed, and the marginal propensity to consume is 0.8.What happens to equilibrium GDP?

Question

Quizplus · Accepted Answer

With a marginal propensity to consume of 0.8, the initial decrease in disposable income due to the $10 billion tax increase will decrease consumption by $8 billion (0.8 x $10 billion). This decrease in consumption will then lead to a decrease in production, in turn decreasing GDP by a multiple of the initial decrease in consumption based on the expenditure approach: (1/1 - MPC) x initial decrease in consumption = (1/0.2) x $8 billion = $40 billion. Therefore, there is a $40 billion decrease in equilibrium GDP.

Suppose the Federal Government Imposes a $10 Billion Tax Increase