Explain the effect of a discretionary cut in taxes of $40 billion on the economy when the economy’s marginal propensity to consume is .75. How does this discretionary fiscal policy differ from a discretionary increase in government spending of $40 billion?
What will be an ideal response?
If MPC is .75, the multiplier is 4. A tax cut of $40 billion will result in initial increase in consumption of $30 billion (.75 ? $40 billion). This initial increase in spending will ultimately result in an increase in consumption spending of $120 billion because of the multiplier process. In contrast, an initial increase in government spending of $40 billion will ultimately increase consumer spending by $160 billion (4 ? $40) because none of the initial increase is siphoned off as savings as would be the case with a $40 billion tax cut.
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