Assume the marginal propensity to consume is 0.8 and potential output is $800 billion. If actual real GDP is $850 billion, which of the following policies would bring the economy to potential output?
A)Increase taxes by $50 billion.
B)Increase taxes by $10 billion.
C)Increase taxes by $12.5 billion.
D)Increase transfers by $12.5 billion.

Question

Quizplus · Accepted Answer

To bring the economy to potential output, we need to decrease aggregate demand. We can achieve this by reducing disposable income, i.e. by either increasing taxes or decreasing transfers.

The MPC (marginal propensity to consume) is 0.8, which means that for every $1 increase in disposable income, consumption will increase by $0.80. Therefore, to decrease aggregate demand by $50 billion, we need to decrease disposable income by $62.5 billion (because 0.8 * $62.5 billion = $50 billion).

Option A, increasing taxes by $50 billion, would decrease disposable income by $50 billion, which is not enough to bring the economy to potential output. Option B, increasing taxes by $10 billion, would only decrease disposable income by $8 billion (0.8 * $10 billion = $8 billion), which is also not enough.

Option D, increasing transfers by $12.5 billion, would increase disposable income, which is not the desired result. Therefore, option C, increasing taxes by $12.5 billion, is the best choice. This would decrease disposable income by $10 billion (0.8 * $12.5 billion = $10 billion), which would reduce aggregate demand and bring the economy closer to potential output.

Assume the Marginal Propensity to Consume Is 0