Question

Suppose inflation is a threat because the current aggregate demand curve will increase by \(\$ 600\) billion at any price level. If the marginal propensity to consume \((M P C)\) is \(0.75,\) federal policymakers could follow Keynesian economics and restrain inflation by a. decreasing taxes by \(\$ 600\) billion. b. decreasing transfer payments by \(\$ 200\) billion. c. increasing taxes by \(\$ 200\) billion. d. increasing government spending by \(\$ 150\) billion.

Short answer

The best fiscal policy actions to restrain inflation according to the Keynesian economics framework are decreasing transfer payments by $200 billion (option b) or increasing taxes by $200 billion (option c). Both of these actions would reduce aggregate demand by $600 billion, counteracting the expected inflation caused by excess aggregate demand.

Step-by-step solution

Understanding the Keynesian expenditure multiplier

The Keynesian expenditure multiplier tells us how much total spending will be affected by an initial change in the level of taxation, government spending, or other forms of spending. Given the marginal propensity to consume (MPC) is 0.75, we can calculate this multiplier using the formula: \[ Multiplier = \frac{1}{1-MPC} \] Substituting MPC = 0.75 into the formula gives: \[ Multiplier = \frac{1}{1-0.75} = 4 \] An expenditure of \(1 would ultimately increase total spending by \)4.

Calculating the effect on aggregate demand for each action

Next, we need to calculate the effect on aggregate demand for each action proposed. a. Decreasing taxes by $600 billion: Since a tax cut puts more income into the hands of consumers, and because they will spend 75% of that income, this will increase aggregate demand by \(600 \times 0.75 = 450 \) billion. Due to the multiplier effect, the change in GDP due to the tax cut would be \(4 \times 450 = 1800\) billion, higher than the notable increase in aggregate demand. b. Decreasing transfer payments by $200 billion: This actually reduces income, and therefore reduces spending. This would have the effect of decreasing aggregate demand by \(200 \times 0.75 = 150 \) billion. Due to the multiplier effect, the overall decrease in GDP is \(4 \times 150 = 600 \) billion, which is equal to the excess increase in aggregate demand. c. Increasing taxes by $200 billion: This reduces income and therefore reduces spending, similar to decreasing transfer payments. The impact on aggregate demand would be a decrease by \(200 \times 0.75 = 150 \) billion. With the multiplier, the total decrease in GDP is \(4 \times 150 = 600 \) billion. It's also equal to the excess increase in aggregate demand. d. Increasing government spending by \(150 billion: This directly increases spending, leading to an increase in aggregate demand by \)150 billion. Multiplied by the expenditure multiplier, the total increase would be \(4 \times 150 = 600 \) billion, which does not help in this case since it is equal to the unwanted increase.

Select the best option

The problem requests that we find a solution to counteract the increase in aggregate demand. Therefore, we need an option that reduces aggregate demand by \(600 billion. From the calculations in Step 2, we can see that both option b (decreasing transfer payments by \)200 billion) and c (increasing taxes by $200 billion) both meet the criteria. So, both option b and c are the correct answers.

Key concepts

Aggregate Demand

Aggregate demand represents the total demand for goods and services in an economy at a specific overall price level and in a given time period. It includes the spending by households, companies, and the government on goods and services. Think of it as the total amount everyone's willing and capable of buying.
This concept is crucial in analyzing an economy's performance. When aggregate demand increases, it usually signals economic growth, leading to higher production and potentially pulling up prices, which can lead to inflation. Conversely, a decrease might indicate an upcoming recession, characterized by reduced economic activity and potentially deflation.
In the Keynesian framework, controlling aggregate demand is vital for managing economic stability. Fluctuations in aggregate demand directly influence employment levels and the general price level in the economy.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is a key concept in Keynesian economics. It measures the portion of additional income that a person spends on consumption rather than saving.
For example, if someone receives an extra dollar and spends 75 cents of it, then their MPC is 0.75.

• MPC ranges between 0 and 1.
• If MPC is high, individuals prefer to spend rather than save.
• A low MPC indicates people prefer saving over spending.

This concept is essential in assessing how a change in income can impact overall economic activity. A higher MPC indicates that any increase in income will lead to a significant rise in spending and consequently, aggregate demand.

Multiplier Effect

The multiplier effect involves how an initial change in economic activity, like increased spending, results in a more significant overall impact on the economy. This phenomenon is due to a chain reaction of spending: an initial increase leads to more income for some, who in turn spend part of it and pass on more income to others, creating a cyclical effect.
The formula for calculating the multiplier is:
\[Multiplier = \frac{1}{1-MPC}\]The multiplier tells us how much total income will change in response to an initial change, like a government spending increase. For instance, if the MPC is 0.75, the multiplier would be 4, meaning every dollar spent ultimately results in four dollars in the overall economy.

• This demonstrates the power of initial spending to significantly shape economic conditions.
• A higher MPC leads to a larger multiplier effect.

A crucial insight here is understanding how seemingly small changes in one area can ripple across the economy.

Fiscal Policy

Fiscal policy is a government's use of spending and taxation to influence the economy. It is a critical tool in Keynesian economics to stabilize the economy over the business cycle.
When an economy faces inflation, as discussed in the original scenario, fiscal policy strategies might include reducing government spending or increasing taxes to decrease aggregate demand and cool off price increases.

• Conversely, during economic slumps, a government may increase spending or lower taxes to boost demand.
• These actions make fiscal policy a handy tool for governments to influence economic outcomes.

Essentially, fiscal policy aims to smoothen out the extremes of the economic cycle, promoting stable growth, manageable inflation, and optimal employment.