Question

If the MPC = 0.80 and taxes are increased by $1,000, the Keynesian model predicts the change in equilibrium GDP will be:

A. +$5,000. B. +$4,000. C. -$1,000. D. -$4,000. E. -$5,000.

Answer 1

The correct answer is option D.

Step-by-step explanation:

The marginal propensity to consume is given as 0.80.

There is a tax increase by $1,000.

This increase in tax will reduce the disposable income, which will further reduce consumption and thus GDP.

The effect of tax increase on the GDP can be calculated through the tax multiplier.

Tax multiplier

=
`(-MPC)/(1-MPC)`

=
`(-0.8)/(1-0.8)`

= -4

The change in GDP

=
`Tax\ multiplier\ *\ Change\ in\ taxes`

=
`-4\ *\ 1,000`

= -4,000