Assume the marginal propensity to consume is 0.8 and potential output is $800 billion. If actual real GDP is $700 billion, which of the following policies would bring the economy to potential output?
A)Decrease taxes by $100 billion.
B)Increase taxes by $100 billion.
C)Decrease taxes by $25 billion.
D)Decrease government transfers by $25 billion.

Question

Quizplus · Accepted Answer

The spending multiplier is 1/(1-MPC) = 1/(1-0.8) = 5. To close a $100 billion gap, a tax decrease of $25 billion would increase consumption by $20 billion, leading to a total increase in GDP of $100 billion (5 * $20 billion).

Assume the Marginal Propensity to Consume Is 0