Whats the answer and explanation to this question According

What\'s the answer and explanation to this question?

According to the Keynesian model, equal increases in government spending and taxes will result in which of the following?

A. Increases in the price level accompanied by increases in output

B. Increased imports due to the effects of interest rate changes on exchange rates

C. Decreased imports due to the effects of tax changes on exchange rates

D. No change in the price level and a decrease in output E. An increase in output and no change in the price level

Solution

E. An increase in output and no change in the price level

In the Keynesian model, prices are assumed to be fixed. Changes in fiscal policy do not affect prices. When government spending and taxes are increased in equal proportion, then the net effect is an increase in output. This is because increase in government spending has full multiplier effect on income as the value of government spending multiplier is higher. On the other hand, an increase in tax reduces income by a smaller amount as the value of tax multiplier is lesser. So, overall income and output rises with no change in price.

Government spending multplier is:

_G = 1/1-c(1-t)

Tax multiplier is:

_G = cY₀/1-c(1-t)