Question

Consider the economy of Arcadia. Its households spend 75% of increases in their income. There are no taxes and no foreign trade. Its currency is the arc. Potential output is 600 billion arcs. Suppose that actual output is 700 billion arcs, and the government of Arcadia decides to tax its citizens. To bring the economy to potential output, the government should:

Answer 1

The economy has an actual output of 700 billion, and its potential ouput was 600 billion, therefore, we can say that the economy is already performing well, beyond potential, for this reason, the government should simply not intervene, because government intervetion reduces the economic efficiency of market outcomes.

If the economy was below potential, the government could tax some of the 25% income that households save, in order to increase spending. This would promote economic growth, bringing the economy closer to potential.