An economy has a fixed price level, no imports, and no...

An economy has a fixed price level, no imports, and no income taxes. $M P C$ is 0.80 , and real GDP is $\$ 150$ billion. Businesses increase investment by $\$ 5$ billion. An economy has a fixed price level, no imports, and no income taxes. An increase in autonomous expenditure of $\$ 2$ trillion increases equilibrium expenditure by $\$ 8$ trillion. Calculate the multiplier and explain what happens to the multiplier if an income tax is introduced.

An economy has a fixed price level, no imports, and no income taxes. $M P C$ is 0.80 , and real GDP is $\$ 150$ billion. Businesses increase investment by $\$ 5$ billion.
An economy has a fixed price level, no imports, and no income taxes. An increase in autonomous expenditure of $\$ 2$ trillion increases equilibrium expenditure by $\$ 8$ trillion. Calculate the multiplier and explain what happens to the multiplier if an income tax is introduced.

Key Concepts

Marginal Propensity to Consume (MPC)

The MPC is a measure of the fraction of additional income that households spend on consumption rather than saving. It is a key determinant of the multiplier effect in Keynesian economics, as higher values of MPC imply that more of any change in income will be spent, thus amplifying the overall impact on aggregate demand.

Keynesian Multiplier

The Keynesian multiplier reflects the change in equilibrium output resulting from a change in autonomous expenditure. It is calculated as one divided by one minus the MPC in a simple model without taxes and imports. The multiplier effect explains how an initial increase in spending can lead to a larger overall increase in national income.

Autonomous Expenditure

Autonomous expenditure refers to spending that is independent of the current level of national income. It includes investments, government spending, and exports. In the multiplier process, changes in autonomous expenditure trigger rounds of income changes, resulting in a cumulative effect on aggregate demand.

Impact of Taxes on the Multiplier

Introducing income taxes reduces the effective MPC since taxes take away a portion of income, leading to a lower marginal propensity to spend out of disposable income. Consequently, the multiplier is diminished because each round of spending is smaller when taxes are present, resulting in a lower overall amplification effect on national income.

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