Assume that a hypothetical economy with an MPC of .8 is...

Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $\mathrm{S} 25$ billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish the same goal.

Key Concepts

Aggregate Demand

Aggregate demand is the total demand for goods and services within an economy at a given overall price level and in a specified period. It encompasses consumption, investment, government spending, and net exports, and shifts in aggregate demand can have significant impacts on overall economic performance, influencing output and employment levels.

Tax Multiplier

The tax multiplier quantifies the effect on aggregate demand of a change in taxes. Unlike direct government spending, a tax cut affects aggregate demand indirectly by increasing disposable income, which then translates into consumption. The effect is usually smaller than that of direct spending due to leakage through savings and the proportion of income not spent.

Government Spending Multiplier

The government spending multiplier measures the total impact on aggregate demand resulting from a change in government expenditure. Since government spending directly injects demand into the economy, the multiplier effect is typically larger, meaning that an initial increase in spending leads to a greater overall elevation in economic activity.

Fiscal Policy

Fiscal policy refers to the use of government spending and taxation decisions by policymakers to influence economic activity. It is a primary tool for stabilizing the economy, stimulating growth during recessions, and controlling inflation during booms.

Marginal Propensity to Consume (MPC)

The MPC is the proportion of additional income that consumers spend rather than save. It is a critical variable in determining how changes in fiscal policy will impact aggregate demand, as a higher MPC implies a larger spending response to income changes, thereby magnifying the overall impact on the economy.

Transcript

00:02 In this situation, the economy is suffering from a recession.

00:08 And the only way for the economy to get out of the recession in this situation is for the aggregate demand to increase by $25 million.

00:29 The mpc in this economy is 0 .8, which means for a certain amount of money that someone earns, they spend 0 .8 amount of that money.

00:42 Because of this formula, mpc plus mps equals 1, we know that the mps is 0 .2.

00:51 Now, to solve this recession, there are three possible ways, government spending, tax cuts, or both.

01:01 Let's start with government spending.

01:05 So to solve for government spending, we know that a certain amount of money, which we could simplify for x for now, times the spending multiplier, which i'll use sm, spending multiplier, equals 25 million.

01:28 So let's solve for the spending multiplier.

01:33 Since from the equation we know spending multiplier is 1 over mpc, i mean mps, the spending multiplier equals to 1 over 0 .2, which is 5.

01:48 So we know that x times 5 equals 25.

01:58 If we divide by 5 on both sides, we know that x equals 5.

02:07 So if government spent $5 million, the recession would end.

02:19 Now let's solve for tax cuts.

02:22 Tax cuts would be a different approach.

02:25 So for this, we would use a certain amount of money that would be a tax cut.

02:31 We'll say x again for this.

02:34 And we would use positive tax multiplier.

02:38 Because the tax is being cut, we don't want to use a negative version of it, which equals 25 million.

02:56 So the tax multiplier is mpc over mps, which would equal negative 4.

03:07 Now for this we want to use the positive version because it's being tax cut.

03:12 So we would do 4x equals 25 million.

03:24 So if you divide 4 by both sides, you can see that the amount of taxes that need to be cut is 6 .25 million...

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