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Scenario: Fiscal Policy
Consider the economy of Arcadia. Its households spend 75% of increases in their income. There are no taxes and no foreign trade. Its currency is the arc. Potential output is 600 billion arcs.
-(Scenario: Fiscal Policy) Look at the scenario Fiscal Policy. Suppose that actual output is 700 billion arcs, and the government of Arcadia decides to tax its citizens. To bring the economy to potential output, the government should:
A)increase taxes by 33.33 billion arcs.
B)increase taxes by 3.33 billion arcs.
C)keep taxes at zero.
D)increase both taxes and government spending by 0.33 billion arcs.

Question

Quizplus · Accepted Answer

To bring the economy to potential output, the government needs to decrease aggregate demand. Since households spend 75% of increases in their income, the government needs to decrease disposable income so that they will spend less. To decrease disposable income, the government needs to increase taxes. The amount of taxes the government needs to increase is calculated by:
AD gap = actual output - potential output
AD gap = 700 billion - 600 billion = 100 billion
Disposable income decrease = 75% x AD gap = 75% x 100 billion = 75 billion
Tax increase required to decrease disposable income by 75 billion = 75 billion/2 = 37.5 billion
Therefore, the government should increase taxes by 33.33 billion arcs (rounded to the nearest 0.01 billion).

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