A government is currently operating with an annual budget deficit of? $40 billion. The government has determined that every ?$10 billion reduction in the amount of bonds it issues each year would reduce the market interest rate by 0.10 percentage point.? Furthermore, it has determined that every 0.10 ?(?one-tenth?) percentage point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to ?$5 billion. The marginal propensity to consume is 0.80. ?Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price? level, it must generate a net leftward shift in the aggregate demand curve equal to ?$60 billion.
Assuming that there are no direct expenditure offsets to fiscal? policy, how much should the government increase? taxes?
?$40.00 billion.?(Enter your response rounded to two decimal? places.)
Ans:
A government is currently operating with an annual budget deficit of? $40 billion. The government has determined that every ?$10 billion reduction in the amount of bonds it issues each year would reduce the market interest rate by a given mequals0.10 percentage point.? Furthermore, it has determined that every 0.10 percentage point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to xequals?$5 billion.? Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price? level, it must generate a net leftward shift in the aggregate demand curve equal to the inflationary gap. Government increases taxes by? $1 billion, interest rate falls by 0.10 percentage points and planned investment expenditure increases by mxequals?$0.50 billion.? Now, when taxes are increased by? $1 billion and because of that tax? increase, AD falls by the amount of the tax multiplierequals StartFraction MPC Over 1 minus MPC EndFraction
.But for every? $1 billion tax? increase, investment increases AD by StartFraction mx Over 1 minus MPC EndFraction
.?Therefore, the net reduction in AD due to? $1 billion increase in taxes equals StartFraction MPC Over 1 minus MPC EndFraction
negative StartFraction mx Over 1 minus MPC EndFraction
equals StartFraction MPC minus mx Over 1 minus MPC EndFraction
.As a? result, to reduce AD by Upper Delta Upper Y?, taxes need to be raised by an amount equals StartFraction Upper Delta Upper Y times left parenthesis 1 minus MPC right parenthesis Over left parenthesis MPC minus mx right parenthesis EndFraction
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