Question

Suppose an economy is producing real GDP of $300 billion. The potential output is equal to $400 billion, and the marginal propensity to consume is equal to 0.80. The government should ____ taxes by _____ to bring the economy to potential output.

Answer 1

The government should LOWER taxes by $25 to bring the economy to potential output.

Step-by-step explanation:

the tax multiplier = -MPC / (1 - MPC) = -0.8 / (1 - 0.8) = -0.8 / 0.2 = -4

if you want to increase GDP by $100 billion, you must cut taxes by $25 billion.

total effect = -$25 billion x -4 = $100 billion increase

that would increase the GDP from its current $300 billion level to $400 billion