Question

If real GDP is $200 billion, full employment GDP is $500 billion, and the marginal propensity to consume is 0.75, then Congress should decrease taxes by $50 billion. increase government purchases by $50 billion. decrease government purchases by $50 billion. decrease taxes by $100 billion. increase government purchases by $300 billion.

Answer 1

The answer is: decrease taxes by $100 billion.

Step-by-step explanation:

If the real GD is $200 billion, which represents only 40% of full employment GDP, then the government should try to increase consumer spending either by decreasing taxes or increasing government spending, or a combination of both.

In this case, I chose the tax decrease since government have budget limitations and they can only decrease taxes by so much before hitting a deficit. Additionally, when you have a large tax reduction, usually government spending either stays the same or decreases.

If the government decreases taxes by $100 billion, the marginal propensity to consume shall result in a $75 billion increase in consumption. According to the Keynesian Multiplier theory, that $75 billion should generate additional production, creating a virtuous cycle that should increase the real GDP in a larger proportion.