Ifthe absolute value of the tax multiplier equals 16 real GD

If(the absolute value of) the tax multiplier equals 1.6, real GDP is $ 13 trillion, and potential real GDP is $13.4 trillion, then taxes would need to be ________ to restore the economy to potential real GDP. (A)

A. cut by $250 billion

B. increased by $1.4 trillion

C. cut by $1.4 trillion

D. increased by $400 billion

E. cut by $400 billion

The answer is A, please explain why.

Solution

Option A

Based on formula of multiplier,

Change in GDP = -Tax multiplier*Change in tax

Change in tax = Change in GDP/-Tax multiplier

= (13.4-13)/-1.6 = 0.4/-1.6 = 0.25 trillion or $250 billion