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Difficulty: Very hardFiscal Policy Tools and Economic Stabilization

An economy with a marginal propensity to consume (MPCMPC) of 0.750.75 experiences a recessionary output gap of $120 billion\$120\text{ billion}. To achieve economic stabilization and eliminate this gap while keeping the government budget strictly balanced, which combination of fiscal policy measures must the government implement?

  1. A
    Increase government expenditure by $30 billion\$30\text{ billion} while keeping tax revenue unchanged
  2. B
    Sell government Treasury bills worth $30 billion\$30\text{ billion} in the open market and reduce direct tax rates
  3. Increase government expenditure by $120 billion\$120\text{ billion} and increase tax revenue by $120 billion\$120\text{ billion}Answer
  4. D
    Increase government expenditure by $24 billion\$24\text{ billion} and reduce tax revenue by $24 billion\$24\text{ billion}

Answer

Increase government expenditure by 120billionandincreasetaxrevenueby120 billion and increase tax revenue by 120 billion
Under the balanced budget multiplier theorem, when government spending and taxes are increased by equal amounts (ΔG=ΔT\Delta G = \Delta T), the positive expansionary effect of government expenditure (kg=4k_g = 4) outweighs the negative contractionary effect of increased taxation (kt=−3k_t = -3). The combined net multiplier is kbb=4−3=1k_{bb} = 4 - 3 = 1. Therefore, to close a recessionary gap of $120 billion\$120\text{ billion} while keeping the budget strictly balanced, both government expenditure and tax revenue must increase by exactly $120 billion\$120\text{ billion}.

Step-by-Step Solution

1
Calculate the individual spending and tax multipliers from the given MPC.
Government spending multiplier kg=11−MPC=11−0.75=4k_g = \frac{1}{1 - MPC} = \frac{1}{1 - 0.75} = 4. Tax multiplier kt=−MPC1−MPC=−0.750.25=−3k_t = \frac{-MPC}{1 - MPC} = \frac{-0.75}{0.25} = -3.
Understanding the individual multipliers is essential to evaluate combined fiscal interventions.
2
Derive the balanced budget multiplier (kbbk_{bb}) for equal changes in government spending (ΔG\Delta G) and taxation (ΔT\Delta T).
kbb=kg+kt=4+(−3)=1k_{bb} = k_g + k_t = 4 + (-3) = 1. Therefore, ΔY=ΔG=ΔT\Delta Y = \Delta G = \Delta T.
The balanced budget requirement dictates that ΔG=ΔT\Delta G = \Delta T, meaning the net national income change equals the expenditure change.
3
Determine the required increase in government expenditure to close the $120 billion recessionary gap.
Since kbb=1k_{bb} = 1, ΔY=$120 billion⇒ΔG=$120 billion\Delta Y = \$120\text{ billion} \Rightarrow \Delta G = \$120\text{ billion} and ΔT=$120 billion\Delta T = \$120\text{ billion}.
To raise aggregate income by $120 billion\$120\text{ billion} without causing a deficit, spending and tax revenue must both rise by $120 billion\$120\text{ billion}.

Key Concept

Balanced Budget Multiplier and Economic Stabilization
Estimated Time:2m 30s
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Topics

Fiscal Policy Tools and Economic Stabilization

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