The nation of Maximus has a marginal propensity to consume

. The nation of Maximus has a marginal propensity to consume of .90 and the government has decreased taxes by a lump-sum amount of $1 billion. Assume there is no international trade or changes to the aggregate price level. a. What is the value of the tax multiplier in Maximus? b. By how much will real GDP change after the $1 billion decrease in taxes? c. If the government wanted to accomplish the same increase in real GDP you found in part (b), but with government spending instead of taxes, would the government need more than $1 billion in spending, less than $1 billion in spending, or exactly $1 billion in spending? Explain.

Solution

a) Tax multipler= -MPC/(1-MPC)

= -0.90/(1-0.90)

=-0.90/0.10

= -9

b) change in GDP= Tax multiplier * change in tax

=-9*(-$1 billion)

= 9 billion

c) change in GDP= 1/(1-MPC) * change in govenment expenditure

9 = 1/(1-0.9) * change in govenment expenditure

9=1/0.10 * change in government expenditure

0.9 billion= change in Government expenditure

i.e less than $1 billion in spending

Note= 1/(1-MPC) is investment multiplier.