Final answer:
The government's fiscal policy involving a decrease in spending by $20 million and an increase in taxes by $15 million, given an MPC of 0.80, will lead to a total reduction in GDP by $160 million.
Step-by-step explanation:
When the government adopts fiscal policy measures to control inflation by decreasing government spending and increasing taxes, it impacts the economy's gross domestic product (GDP). In this scenario, with a government spending cut of $20 million and tax increase of $15 million, and given a marginal propensity to consume (MPC) of 0.80, we can analyze the effect of these changes on GDP.
The multiplier effect in economics states that a change in spending can result in a larger change in the aggregate income and GDP. The size of the multiplier is calculated as 1/(1-MPC). With an MPC of 0.80, the multiplier would be 1 / (1 - 0.80) = 5. Therefore, a $20 million cut in spending would result in a $100 million decrease in GDP ($20 million x 5). Additionally, the $15 million increase in taxes would reduce consumption by $15 million x MPC. Since the MPC is 0.80, consumption would fall by $12 million ($15 million x 0.80), and therefore, the additional reduction in GDP would be $12 million x multiplier, or $60 million. In total, the combined effect on GDP from both policies would be a reduction of $160 million ($100 million + $60 million).