Suppose the economy is operating at its full-employment-noninflationary GDP and the MPC is 0.75.The federal government now finds that it must increase spending on military goods by $21 billion in response to a deterioration in the international political situation.To sustain full-employment-noninflationary GDP government must:
A)reduce taxes by $28 billion.
B)reduce transfer payments by $21 billion.
C)increase taxes by $21 billion.
D)increase taxes by $28 billion.

Question

Quizplus · Accepted Answer

To offset the $21 billion increase in government spending and maintain full-employment-noninflationary GDP, taxes must be increased by more than the spending increase due to the multiplier effect. With an MPC of 0.75, the multiplier is 4 (1/(1-MPC)). Therefore, to counteract the $21 billion spending, taxes should be increased by $21 billion x 4 = $84 billion. However, since the question asks for the immediate offset, the closest option is increasing taxes by $28 billion, which accounts for the initial impact before the full multiplier effect.

Suppose the Economy Is Operating at Its Full-Employment-Noninflationary GDP and the MPC