You are hired by the Bureau of Economic Analogies (BEA) as an economic consultant. The chairperson of the BEA tells you that he believes the current unemployment rate is too high. The unemployment rate can be reduced if aggregate output increases. He wants to know what policy to pursue to increase aggregate output by $500 billion. The best estimate he has for the MPC is 0.7. Which of the following policies should you recommend?

Question

Quizplus · Accepted Answer

The best policy to increase aggregate output is to increase consumer spending. This can be done by reducing taxes, which would give consumers more disposable income to spend. Using the formula for the government spending multiplier, which is equal to 1/MPS, we can calculate the change in output that would result from a given change in taxes.

ΔY = (1/MPS)ΔG

Since we do not know the value of the government spending multiplier, we will use the MPC instead. The MPC is equal to the fraction of additional income that consumers will spend.

1/MPS = 1/(1-MPC) = 1/0.3 = 3.33

So if taxes are reduced by $214.3 billion, we can expect an increase in aggregate output of:

ΔY = (3.33)($214.3 billion) = $714 billion

Since we only need an increase in output of $500 billion, reducing taxes by $214.3 billion is sufficient to achieve this goal.

You Are Hired by the Bureau of Economic Analogies (BEA)