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 needs to increase aggregate demand. Since the marginal propensity to consume is 0.80, the multiplier effect will be 5 (1/0.20 = 5). Therefore, to increase aggregate demand by $100 billion ($400 billion - $300 billion), the government needs to reduce taxes by $20 billion ($100 billion/5). Thus, the correct choice is to cut taxes by $25 billion, which is not one of the given options. The closest option is to cut taxes by $20 billion (choice D), which will be effective in increasing aggregate demand by $80 billion (4 x $20 billion), bringing the economy closer to potential output.

Suppose an Economy Is Producing Real GDP of $300 Billion