Question

An economy is experiencing a high rate of inflation. The government wants to reduce aggregate demand by $36 billion to reduce inflationary pressure. The MPC is 0.75. By how much should the government raise taxes to achieve its objective

Answer 1

The government should raise taxes by $27 billion to reduce inflationary pressure.

Step-by-step explanation:

In this scenario, the government wants to reduce aggregate demand by $36 billion to relieve inflationary pressures. To achieve this, the government can increase taxes on consumers or firms.

Given that the MPC is 0.75, we can use the formula: Change in aggregate demand = change in taxes / MPC.

The change in taxes would be $36 billion x 0.75, which is $27 billion. So, the government should raise taxes by $27 billion to achieve its objective.

Answer 2

To reduce inflationary pressure, the government should raise taxes by $9 billion, leveraging the multiplier effect that corresponds to the given MPC of 0.75, in order to reduce aggregate demand by the desired $36 billion.

Step-by-step explanation:

To combat high inflation, the government can utilize fiscal policy measures to decrease aggregate demand. Specifically, to reduce inflationary pressure, the government may raise taxes or lower spending. Given a marginal propensity to consume (MPC) of 0.75, the reduction in aggregate demand desired is $36 billion. The fiscal multiplier in this scenario is the reciprocal of the marginal propensity to save (MPS), which is 1 minus the MPC, therefore the multiplier is 1 / (1 - 0.75) = 4. To achieve a $36 billion reduction in aggregate demand, the government should raise taxes by the amount of the desired decrease divided by the multiplier, which is $36 billion / 4 = $9 billion.