Suppose that the current equilibrium GDP is $14.5 trillion and that potential GDP is $14.3 trillion. Will decreasing government purchases by $200 billion, or raising taxes by $200 billion, restore the economy to potential GDP? Explain
What will be an ideal response?
Neither policy is appropriate because they ignore the multiplier effect. The multiplier effect multiplies each dollar of government purchases into larger changes in equilibrium GDP. This means that it will take a much smaller decrease in government purchases than 0.2 trillion to close the gap between equilibrium GDP and potential GDP. Since the multiplier effect of a dollar change in taxes is smaller than the multiplier effect of government purchases, the absolute value of the tax increase will have to be larger than the change in government purchases.
This is clearly shown by assuming the value of the government purchase multiplier is equal to 2.5 and a tax multiplier equal to -1.5.
The necessary increase in government purchases is
Government purchases multiplier =
2.5 =
Change in government purchases = = -$80 billion
And the necessary change in taxes:
Tax multiplier =
-1.5 =
Change in taxes = = $133.33 billion
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