Suppose an economy is producing real GDP of $300 billion. The potential output is equal to $400 billion, and the marginal propensity to consume is equal to 0.80. The government should _____ taxes by _____ to bring the economy to potential output.

Question

Quizplus · Accepted Answer

To bring the economy to potential output, the government should decrease taxes. The formula for calculating the fiscal policy change needed to reach potential output is:

Fiscal change = (1 - MPC) x (Yp - Y)

Where MPC is the marginal propensity to consume, Yp is potential output, and Y is actual output.

So, plugging in the given information:

Fiscal change = (1 - 0.80) x ($400 billion - $300 billion)
Fiscal change = 0.20 x $100 billion
Fiscal change = $20 billion

Therefore, taxes should be cut by $20 billion. However, none of the answer choices match this amount exactly. The closest choice is D, which advocates for cutting taxes by $25 billion, so that would be the best option among the given choices.

Suppose an Economy Is Producing Real GDP of $300 Billion