Suppose the economy is operating at its fullemploymentnoninf

Suppose the economy is operating at its full-employment-noninflationary GDP and the MPC is 0.8. The Federal government now finds that it must increase spending on military goods by $20 billion in response to deterioration in the international political situation. To sustain full-employment-noninflationary GDP government must:
A. reduce taxes by $20 billion.
B. increase transfer payments by $20 billion.
C. increase taxes by $20 billion.
D. increase taxes by $25 billion.

Solution

Option D is correct.

If the economy is operating at its full employment non-inflationary GDP And if MPC is 0.8 then,

1/(1-MPC) = 1/(1-0.8) = 1/0.2 = 5

When spending increases by 20 billion , taxes has to be increased by 20+5 billion, that is 25 billion.

The non inflationary government increases taxes by a little higher amount than the amount it spends on goods and expenditures.