If short-run equilibrium output equals 10,000, the income-expenditure multiplier equals 5, the MPC equals .8, and potential output (Y*) equals 9000, then taxes must ______ by ________ to eliminate any output gap.Group of answer choicesdecrease, 20increase, 200increase, 225increase, 250decrease, 200
Question
If short-run equilibrium output equals 10,000, the income-expenditure multiplier equals 5, the MPC equals .8, and potential output (Y*) equals 9000, then taxes must ______ by ________ to eliminate any output gap.Group of answer choicesdecrease, 20increase, 200increase, 225increase, 250decrease, 200
Solution
In this scenario, the short-run equilibrium output (10,000) is greater than the potential output (9,000), indicating an inflationary gap of 1,000 (10,000 - 9,000). To eliminate this output gap, the government needs to decrease aggregate demand. One way to do this is by increasing taxes, which reduces disposable income and thus consumption.
The income-expenditure multiplier is given as 5. This multiplier is the reciprocal of the marginal propensity to save (MPS), which is 1 - MPC. Given that the MPC is 0.8, the MPS is 0.2, and the multiplier is indeed 5 (1/0.2).
To find out by how much taxes need to increase, we divide the output gap by the multiplier. So, 1,000 / 5 = 200.
Therefore, to eliminate the output gap, taxes must increase by 200. So, the correct answer is "increase, 200".
Similar Questions
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