Question

Suppose the government, in an effort to avoid an increase in the deficit, votes for a budget neutral tax cut policy. Assume the marginal propensity to consume (MPC) is equal to 0.85 and taxes are cut by $8 billion. Round answers to the nearest billion, and specify decreases as a negative number.
A. By how much will government spending change?
B. What is the resulting change in the equilibrium level of real GDP?

Answer 1

PART A:

The government has voted for budget neutral tax cut policy in order to avoid the enhancement in the deficit. Thereby, government spending will be reduced by an amount of $8 billion.  

PART B:

The calculation for fall in GDP is as follows:  

$\text { Change in } G D P=\frac{-M P C}{1-M P C}$

Multiply with change in government expenditure,

$\Rightarrow\frac{1}{1-0.85} \rightarrow \text { multiply with }(-8)=-53.33 \text { billion }$

Thus, if the government expense is reduced by $8 billion then fall in GDP is by $53.33 billion  

EFFECT ON GDP DUE TO REDUCTION OF TAX:

$\text { Change in taxes }=\frac{-M P C}{1-M P C}$

Multiply with change in tax,

$\Rightarrow \frac{-0.85}{1-0.85} \rightarrow \text { multiply with }(-8)=45.33 \text { million }$

Thus, when the taxes are reduced by $8 billion, then GDP shows an increase by $45.33 billion.

Therefore, change in equilibrium level of real GDP = -$8 billion ( -53.33 billion + 45.33 billion).