Suppose the federal government increases taxes by $500 million.Assume that taxes are fixed, the economy is closed, and the marginal propensity to consume is 0.75.What happens to equilibrium GDP?

Question

Quizplus · Accepted Answer

With a closed economy and fixed taxes, the government's increase in taxes directly reduces the disposable income of individuals and decreases consumption spending. The multiplier effect magnifies the initial reduction in spending by a factor equal to the inverse of the marginal propensity to consume. So, the initial $500 million reduction in disposable income leads to a decrease in consumption spending of 0.75 x $500 million = $375 million. The multiplier effect of 1/0.75 = 4/3 implies that equilibrium GDP will decrease by 4/3 x $375 million = $500 million. Therefore, the overall effect of the tax increase is a reduction in equilibrium GDP by $500 million + $500 million = $1 billion.

Suppose the Federal Government Increases Taxes by $500 Million