If there is a recessionary expenditure gap of $100 billion and the MPC is 0.80, by how much must taxes be reduced to eliminate the recessionary expenditure gap?
What will be an ideal response?
If the MPC is 0.80, then the MPS is 0.20 and the multiplier is equal to 5. Thus to reduce a gap of $100 billion, taxes must be reduced by $25 billion, which is equivalent to saying that disposable income rises by $25 billion. An increase in income of $25 billion will cause an initial change in spending of $20 billion (or 0.8 ? $25) and this multiplied by 5 will result in an increase in GDP of $100 billion which is the amount of the recessionary expenditure gap.
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