Final answer:
A $400 increase in government spending and a $600 tax cut, with an MPC of 0.75, leads to a total impact of $3400 on GDP due to the multiplier effect. The increase in spending and tax cut result in larger overall GDP increases than their initial amounts due to households' propensity to spend part of their additional income.
Step-by-step explanation:
To determine the change in output (GDP) due to a $400 increase in government spending and a $600 tax cut, we use the concept of the multiplier effect within Keynesian economics. The Marginal Propensity to Consume (MPC) is given as 0.75, which is the proportion of additional income that households will spend rather than save.
The formula for the spending multiplier is 1/(1-MPC). With an MPC of 0.75, the multiplier is 1/(1-0.75) = 4. Therefore, an initial change in spending will have four times the initial impact on the equilibrium level of GDP.
The increase in government spending alone would lead to a change in GDP of $400 × 4 = $1600. A tax cut increases household's disposable income, which leads to additional consumption. With an MPC of 0.75, the $600 tax cut leads to an increase in consumption by 0.75 × $600 = $450. This increase in consumption also has a multiplier effect, so the total impact on GDP would be $450 × 4 = $1800.
Adding the two together, the total effect on GDP from the increase in government spending and the tax cut would be $1600 (from spending) + $1800 (from tax cut) = $3400.
These policy tools should be used in the context of stimulating economic activity during a downturn or when the economy is operating below its potential output to move towards full employment GDP.