30-2 (Key Question) Assume that a hypothetical economy with an MPC of .8 is experiencing
severe recession. By how much would government spending have to increase to shift the
aggregate demand curve rightward by $25 billion? How large a tax cut would be needed
to achieve this same increase in aggregate demand? Why the difference? Determine one
possible combination of government spending increases and tax decreases that would
accomplish this same goal.
In this problem, the multiplier is 1/.2 or 5 so, the required increase in government
spending = $5 billion.
For the tax cut question, initial spending of $5 billion is still required, but only .8 (=
MPC) of a tax cut will be spent. So .8 x tax cut = $5 billion or tax cut = $6.25 billion.
Part of the tax reduction ($1.25 billion) is saved, not spent.
One combination: a $1 billion increase in government spending and a $5 billion tax cut.
Alternatively, one could raise both government spending and taxes by $25 billion.
30-3 (Key Question) What are government’s fiscal policy options for ending severe
demand-pull inflation? Which of these fiscal policy options do you think might be
favored by a person who wants to preserve the size of government? A person who thinks
the public sector is too large? How does the ‘ratchet effect’ affect anti-inflationary policy.
Options are to reduce government spending, increase taxes, or some combination of both.
See Figure 30.2. If the price level is flexible downward, it will fall. In the real world, the
goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price
level. A person wanting to preserve the size of government might favor a tax hike and
would want to preserve government spending programs. Someone who thinks that the
public sector is too large might favor cuts in government spending since this would
reduce the size of government. The ratchet effect implies that prices are rigid downward.
30-6 (Key Question) Define the “standardized budget,” explain its significance, and state why
