Assume That A Hypothetical Economy With An MPC Of 0.75 Is Ex

Assume That A Hypothetical Economy With An Mpc Of 075 Is Experiencing

Assume that a hypothetical economy with an MPC of 0.75 is experiencing a severe recession. To stimulate the economy, the government aims to shift the aggregate demand (AD) curve rightward by $50 billion. This involves calculating how much government spending must increase and the size of tax cuts needed to achieve this goal. Additionally, a combination of government spending increases and tax decreases that sum to the same effect will be explored.

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The marginal propensity to consume (MPC) is a critical factor in fiscal policy effectiveness, particularly in determining the multiplier effect of government spending and tax cuts during economic downturns. With an MPC of 0.75, consumers spend approximately 75% of any additional income, which significantly amplifies fiscal policy impacts on aggregate demand (Mankiw, 2018). In this context, a severe recession prompts policymakers to utilize expansionary fiscal measures—namely, increasing government spending and reducing taxes—to stimulate economic activity and restore growth.

Calculating the Required Increase in Government Spending

The fiscal multiplier for government spending is given by the formula:

Multiplier = 1 / (1 - MPC)

Substituting the given MPC of 0.75, we get:

Multiplier = 1 / (1 - 0.75) = 1 / 0.25 = 4

This means that each dollar of government spending generates four dollars in total increase in aggregate demand. To achieve a $50 billion rightward shift in AD, the required increase in government spending (ΔG) is calculated as:

ΔG = Desired change in AD / Multiplier = $50 billion / 4 = $12.50 billion

Therefore, the government must increase spending by approximately $12.50 billion.

Calculating the Necessary Tax Cut

The tax multiplier differs from the spending multiplier, being equal to:

Tax Multiplier = -MPC / (1 - MPC)

Inserting MPC of 0.75:

Tax Multiplier = -0.75 / 0.25 = -3

The negative sign indicates that a tax cut increases aggregate demand. The magnitude of the required tax cut (ΔT) to produce the same $50 billion increase is:

ΔT = Desired change in AD / |Tax Multiplier| = $50 billion / 3 ≈ $16.67 billion

Thus, a tax cut of approximately $16.67 billion would be necessary to generate the equivalent increase in aggregate demand.

Combining Government Spending and Tax Cuts

A plausible combination involves allocating part of the $50 billion target to government spending increases and the rest to tax cuts. For example, increasing government spending by $12.50 billion (the amount calculated above) combined with a tax cut of $16.67 billion would jointly stimulate the economy to reach the same $50 billion shift in AD. This approach provides flexibility in policy implementation, allowing policymakers to choose a mix based on political and economic considerations.

In summary, to counteract a severe recession with an MPC of 0.75 and achieve a $50 billion increase in aggregate demand, the government should increase spending by approximately $12.50 billion and implement a tax cut of roughly $16.67 billion. These measures leverage the multiplier effect, ultimately stimulating economic activity and facilitating recovery.

References

  • Mankiw, N. G. (2018). Principles of Economics (8th ed.). Cengage Learning.
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  • Krugman, P., & Wells, R. (2020). Macroeconomics (6th ed.). Worth Publishers.
  • Friedman, M. (1957). A Theory of the Consumption Function. Princeton University Press.
  • Harberger, A. C. (2003). Lessons from the debt crisis. Journal of Economic Perspectives, 17(2), 73-96.
  • Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press.
  • Case, K. E., Fair, R. C., & Oster, S. M. (2017). Principles of Economics (12th ed.). Pearson.
  • Romer, D. (2019). Advanced Macroeconomics (5th ed.). McGraw-Hill Education.
  • Impagliazzo, J., & Tuomala, M. (2019). Fiscal policy and economic recovery. Journal of Policy Modeling, 41(4), 606-621.
  • International Monetary Fund. (2021). Fiscal Policy and Economic Recovery. IMF Publications.

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