Question

A government is currently operating with an annual budget deficit of $\backslash (40$ billion. The government has determined that every $\backslash )10$ billion reduction in the amount it borrows each year would reduce the market interest rate by $0.1$ percentage point. Furthermore, it has determined that every $0.1$-percentage-point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to $\backslash (5$ billion. The marginal propensity to consume is $0.75$. Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price level, it must generate a net leftward shift in the aggregate demand curve equal to $\backslash )40$ billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? (Hint: How much new private investment spending is induced by each $\$10$ billion decrease in government spending? )

Short answer

As a result, the amount of tax hike that reduces aggregate demand by $\$40$ billion is $\$40$ billion.

Step-by-step solution

Introduction 

The given is the annual budget deficit of the government $\$40$billion

The objective is to determine how much should the government increase taxes

Explanation  

Every ten-billion-dollar reduction in the amount the government borrows boosts private investment by five-billion-dollars. In other words, for every $x$ reduction in government borrowing, $0.5x$ dollars is lost in private investment.

$0.75$ is the marginal propensity to consume.

Explanation 

To achieve a net leftward shift of $\$40$ billion in the aggregate demand curve, the government must raise taxes. To put it another way, the government needs to raise taxes to produce a net reduction in aggregate demand of $\$40$ billion.

Calculation 

Assume that an increase in taxes of $x$reduces aggregate demand by $\$40$billion.

Changes in AD are solely related to a tax increase of $x$dollars.

$=\frac{-MPC}{1-MPC}\times x$

$$\begin{gathered} =\frac{-0.75}{1-0.75}\times x \\ =-3x \end{gathered}$$

An increase in tax of $x$dollars will result in a decrease in government borrowing of $x$dollars, which will result in a decrease in private investment of $0.5x$dollars.

Change in $mathrmAD$ as a result of a drop in private investment of $0.5x$dollars.

$=\frac{1}{1-MPC}\times 0.5x$

$$\begin{gathered} =\frac{1}{1-0.75}\times 0.5x \\ =2x \end{gathered}$$

Calculate the value of $x$as follows:

Total change in $\mathrm{AD}=-\$40$billion$(-3x)+\left(2x\right)=-\$40$billion

$$\begin{gathered} -x=-40billion \\ x=40billion \end{gathered}$$

As a result, a tax increase of $\$40$ billion reduces aggregate demand by $\$40$ billion.