Assume that marginal propensity to consume is 0.8 and potential output is $800 billion. The tax multiplier is , and the transfer multiplier is _:
a. 0.8, 0.8.
b. 0.2, 0.25
c. 5, 4
d. 4, 4.
The correct answer and explanation is :
The correct answer is:
c. 5, 4
Explanation:
1. Understanding the Tax Multiplier
The tax multiplier (( TM )) measures the change in output due to a change in taxes and is given by the formula:
[
TM = -\frac{MPC}{1 – MPC}
]
where MPC (Marginal Propensity to Consume) is 0.8. Substituting the given value:
[
TM = -\frac{0.8}{1 – 0.8} = -\frac{0.8}{0.2} = -4
]
Since a tax increase reduces output, the tax multiplier is negative. However, when asked for the absolute value, we consider 4.
2. Understanding the Transfer Multiplier
The transfer multiplier (( TRM )) measures the change in output due to a change in government transfer payments. Since transfers are direct payments that add to disposable income, they initially have the same effect as taxes but in the opposite direction. The formula for the transfer multiplier is:
[
TRM = \frac{MPC}{1 – MPC}
]
Substituting the values:
[
TRM = \frac{0.8}{1 – 0.8} = \frac{0.8}{0.2} = 4
]
3. Understanding the Relationship Between Multipliers
The government spending multiplier is:
[
GM = \frac{1}{1 – MPC} = \frac{1}{0.2} = 5
]
Since the tax multiplier is always 1 unit less than the spending multiplier, the tax multiplier is 4, and the transfer multiplier is also 4.
Thus, the correct answer is 5 (spending multiplier), 4 (transfer multiplier), corresponding to option (c).