A $100 increase in government purchases will have exactly the same effect on equilibrium real GDP as a $125 decrease in autonomous net taxes when the MPC equals 0.8.

Question

Quizplus · Accepted Answer

When the MPC (marginal propensity to consume) equals 0.8, this means that for every additional dollar of disposable income, individuals will spend 80 cents and save 20 cents. Therefore, a $100 increase in government purchases will generate an increase in output and income equal to 1 / (1 - MPC) times the increase in government purchases, which is 1 / (1-0.8) x $100 = $500. On the other hand, a $125 decrease in autonomous net taxes will generate a decrease in disposable income equal to the amount of the tax cut (since there is no offsetting change in transfer payments or government purchases). The change in equilibrium output and income will then be equal to MPC times the change in disposable income, which is 0.8 x (-$125) = -$100. Therefore, the impact on equilibrium GDP will be the same as that of a $100 increase in government purchases.

A $100 Increase in Government Purchases Will Have Exactly the Same