Question

If real GDP is $400 billion, full employment GDP is $800 billion, and the marginal propensity to consume is 0.5, then Congress should

a. decrease taxes by $200 billion.

b. increase taxes by $400 billion.

c. increase purchases by an amount slightly more than $200 billion.

d. increase purchases by $200 billion.

e. increase purchases by $400 billion.
Please explain! Not sure how to do this type of problem!

Answer 1

a. decrease taxes by $200 billion

Step-by-step explanation:

Given that;

Real GDP = $400 billion

Employment GDP = $800 billion

Marginal propensity to consume(MPC) = 0.5

We will apply the formula for inflationary gap and tax multiplier.

Inflationary gap = Real GDP - Full employment GDP

= ($400 billion - $800 billion)

= -$400 billion

Also,

Tax multiplier = 1 / 1 - MPC

= 1 / 1 - 0.5

= 1 / 0.5

= 2.

In the light of the above, we can say that ;

increase real GDP by $400 billion and tax should decrease by $200 billion I.e

= -$400 billion / 2

= -$200 billion

Hence, the correct option is A, decrease taxes by $200 billion.