Question

The multiplier effect occurs when an initial increase (or decrease) in autonomous expenditure produces a greater increase (or decrease) in real GDP than the initial change.

In which type of discretionary fiscal policy does the multiplier play a role?
a. government spending changes only
b. both government spending changes and tax changes
c. neither government spending changes nor tax changes
d. tax changes only

Assume a marginal propensity to consume (MPC) of 0.5.

Which discretionary fiscal policy would have a more pronounced impact on the economy?
a. A 800 billion dollar increase in government spending, or a 800 billion dollar tax cut, would both have an equal impact on the economy.
b. A 800 billion dollar tax cut would have a more pronounced impact on the economy.
c. A 800 billion dollar increase in government spending would have a more pronounced impact on the economy.

Answer 1

- both government spending changes and tax changes

- A 800 billion dollar increase in government spending would have a more pronounced impact on the economy

Step-by-step explanation:

The multiplier plays a role in both government spending changes and tax changes. The multiplier depends on the MPC.

Multiplier = 1 / (1 − MPC)

If the government increases spending, the money spent will travel through the economy multiple times: once when the government spends the money and again as inviduals and businesses spend the money over and over. The amount that is spent in each round depends on the MPC. The same multiplier effect applies, for example, if the government cuts taxes.

The increase in government spending will have a larger impact on the economy. With government spending, the amount of increased spending is multiplied by the multiplier to figure out how much total economic impact the policy will have.

With a tax cut, some of the initial tax cut will be saved right away and therefore taken out of the spending cycle of the economy. Given the MPC of 0.5 in this problem, half of the tax cut will saved, leaving only the other half to travel through the economy according to the multiplier. Therefore, a tax cut has a less pronounced impact on an economy than government spending.