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 0.75. Which of the following policies should you recommend?

Question

Quizplus · Accepted Answer

Increasing both government spending and taxes by $500 billion can increase aggregate output. The increase in government spending directly increases aggregate demand, while the increase in taxes reduces disposable income less than the increase in government spending due to the multiplier effect associated with the marginal propensity to consume (MPC). Since the MPC is 0.75, the multiplier is 4 (1/(1-MPC)), meaning that every dollar spent by the government has a multiplied effect on the economy, leading to a larger increase in aggregate output than the decrease caused by higher taxes.

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