There are two groups of households in an economy: groups 1 and 2 Group 1: High i
ID: 1181391 • Letter: T
Question
There are two groups of households in an economy: groups 1 and 2
Group 1: High income families. MPC is about 0.1
Group 2: All other families. When they lose their job, they reduce spending. MPC is about 0.8.
The government can cut taxes by $200 billion or increase transfer payments for some or all of the other families. Both programs cannot be done, and both cost $200 billion per year.
A) Whether the government cuts taxes by $200 billion or increases transfer payments by $200 billion, the initial effect on disposable income is the same. By how much does disposable income initially change?
B) If the government cuts taxes, by how much will the equilibrium income change. Show work.
C) If the government raises transfer payments, by how much will equilibrium income change?
D) Which policy should be adopted?
***I know the multiplier needs to be calculated to find total change in income but I don't know how.
Explanation / Answer
A) Whether the government cuts taxes by $200 billion or increases transfer payments by $200 billion, the initial effect on disposable income is the same. By how much does disposable income initially change?
Consider a $2000 billion tax cut and an MPC of .1. The initial increase in consumption will be
$200 billion x .1 = $20 billion.
multiplier = 1/(1-.1) = 1.11
The total increase in AD will be
$20billion x 1.11 = $22.2 billion.
Recall that a $177.8 billion increase in spending increased AD by $200 billion. Thus a tax cut is less powerful than a spending increase of the same size.