1.5. Show why a $10 billion reduction in government purchases of goods and services will have a...
Question:
1.5. Show why a $10 billion reduction in government purchases of goods and services will have a larger effect on real GDP than a
$10 billion reduction in government transfers by completing the accompanying table for an economy with a marginal propensity to consume (MPC) of 0.6. The first and second rows of the table are filled in for you: on the left side of the table, in the first row, the $10 billion reduction in government purchases decreases real GDP and disposable income, YD, by
$10 billion, leading to a reduction in consumer spending of $6
billion (MPC × change in disposable income) in row 2. However, on the right side of the table, the $10 billion reduction in transfers has no effect on real GDP in round 1 but does lower YD by $10 billion, resulting in a decrease in consumer spending of $6 billion in round 2.
a. When government purchases decrease by $10 billion, what is the sum of the changes in real GDP after the 10 rounds?
b. When the government reduces transfers by $10 billion, what is the sum of the changes in real GDP after the 10 rounds?
c. Using the formula for the multiplier for changes in government purchases and for changes in transfers, calculate the total change in real GDP due to the $10 billion decrease in government purchases and the $10 billion reduction in transfers. What explains the difference? (Hint: the multiplier for government purchases of goods and services is 1/(1 – MPC). But since each $1 change in government transfers only leads to an initial change in real GDP of MPC × $1, the multiplier for government transfers is MPC/(1 – MPC).)
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