What Happens to an Economy in a Recessionary Gap with Changes in Government Spending and Taxes?
Effect of Increase in Government Spending:
Government Spending: When the government increases spending by $100 million, it injects money into the economy, leading to an increase in aggregate demand. This increase in government spending will directly boost the GDP of the economy by an equivalent amount.
Effect of Increase in Taxes:
Taxes: The government's decision to increase taxes by $100 million will reduce the disposable income of individuals and households. This decrease in disposable income may lead to a decrease in consumer spending, as individuals have less money to spend on goods and services.
Impact of MPC on Consumer Spending:
Marginal Propensity to Consume (MPC): With an MPC of 0.8, individuals are likely to spend a significant portion of any additional income they receive. In this scenario, consumers would spend 80% of the $100 million increase in government spending. This increase in consumer spending will further stimulate aggregate demand in the economy.
Overall Economic Impact:
The combination of increased government spending and higher taxes will have a mixed impact on the economy. The increase in government spending will boost GDP and aggregate demand, leading to economic growth. However, the increase in taxes may dampen consumer spending, potentially offsetting some of the benefits of higher government spending.
In conclusion, in an economy with a recessionary gap, an increase in government spending combined with higher taxes can have complex effects on the overall economy. The MPC plays a key role in determining how individuals and households will respond to changes in income and government policies.