The Tax Multiplier Exercise 2 (Algo) Suppose a country's MPC is 0.8, and in this country, government seeks to boost real GDP by either increasing government purchases by $50 billion or by reducing taxes by the same amount. Instructions:

a. If it increases government purchases, real GDP will increase by $ billion, suggesting an expenditures multiplier of . If the government instead lowers taxes, real GDP will increase by $ billion, suggesting a tax multiplier of .

b. Now suppose another country's MPC is 0.6, and in this country, government seeks to reduce real GDP by either decreasing government purchases by $50 billion or by raising taxes by the same amount. If it decreases government purchases, real GDP will decrease by $ billion, suggesting an expenditures multiplier of . If the government instead raises taxes, real GDP will decrease by $ billion, suggesting a tax multiplier of .

c. Which of the following statements best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier?

a. If the government increases government purchases, real GDP will increase by $250 billion, suggesting an expenditures multiplier of 5.  If the government instead lowers taxes, real GDP will increase by $200 billion, suggesting a tax multiplier of -4.

b. If this another country decreases government purchases, real GDP will decrease by $125 billion, suggesting an expenditures multiplier of 2.5.  If the government instead raises taxes, real GDP will decrease by $75 billion, suggesting a tax multiplier of -1.5.

c. The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut.

Explanation:

Multiplier = 1/(1-MPC) = 1/MPS

Tax multiplier = - MPC/MPS

a. If it increases government purchases, real GDP will increase by $ billion, suggesting an expenditures multiplier of . If the government instead lowers taxes, real GDP will increase by $ billion, suggesting a tax multiplier of .

MPC = 0.8

MPS = 1 - 0.8 = 0.2

Multiplier = 1/0.2 = 5

Tax multiplier = - MPC/MPS = 0.8/0.2 = - 4

Effect of $50 billion increase in government purchases = 5 * $50 billion = $250 billion

Effect of $50 billion decrease in tax = -4 * (-$50 billion) = $200 billion

Therefore, If the government increases government purchases, real GDP will increase by $250 billion, suggesting an expenditures multiplier of 5.

If the government instead lowers taxes, real GDP will increase by $200 billion, suggesting a tax multiplier of -4.

b. Now suppose another country's MPC is 0.6, and in this country, government seeks to reduce real GDP by either decreasing government purchases by $50 billion or by raising taxes by the same amount. If it decreases government purchases, real GDP will decrease by $ billion, suggesting an expenditures multiplier of . If the government instead raises taxes, real GDP will decrease by $ billion, suggesting a tax multiplier of

MPC = 0.6

MPS = 1 - 0.6 = 0.4

Multiplier = 1/0.4 = 2.50

Tax multiplier = - MPC/MPS = - 0.6/0.4 = - 1.50

Effect of $50 billion decrease in government purchases = 2.50 * (-$50 billion) = - $125 billion

Effect of $50 billion decrease in tax = -1.50 * ($50 billion) = - $75 billion

Therefore, If this another country decreases government purchases, real GDP will decrease by $125 billion, suggesting an expenditures multiplier of 2.5.  If the government instead raises taxes, real GDP will decrease by $75 billion, suggesting a tax multiplier of -1.5.

c. Which of the following statements best explains the difference in magnitude of the multiplier effects between the expenditures multiplier and the tax multiplier?

The tax multiplier is smaller since some of the extra disposable income is saved with a tax cut.