Classic model economy and economic fluctuation Question and answers
1. The government raises taxes by €100billion. If the marginal propensity to
consume is 0.6, what happens to the following? Do they rise or fall? By what
amount?
(a) Public saving.
(b) Private saving.
(c) National saving.
(d) Investment.
The effect of a government tax increase of €100 billion on (a) public saving, (b)
private saving, and (c) national saving can be analyzed by using the following
relationships:
National Saving = [Private Saving] + [Public Saving]
= [Y – T – C(Y – T)] + [T – G]
= Y – C(Y – T) – G.
(a) Public Saving—The tax increase causes a 1-for-1 increase in public saving. T
increases by €100 billion and, therefore, public saving increases by €100 billion.
(b) Private Saving—The increase in taxes decreases disposable income, Y – T, by
€100 billion. Since the marginal propensity to consume (MPC) is 0.6, consumption
falls by 0.6 × €100 billion, or €60 billion. Hence,
(c) National Saving—Because national saving is the sum of private and public
saving, we can conclude that the €100 billion tax increase leads to a €60 billion
increase in national saving.
Another way to see this is by using the third equation for national saving expressed
above, that national saving equals Y – C(Y – T) – G. The €100 billion tax increase
reduces disposable income and causes consumption to fall by €60 billion. Since
neither G nor Y changes, national saving thus rises by €60 billion.
(d) Investment—To determine the effect of the tax increase on investment, recall the
national accounts identity:
Y = C(Y – T) + I(r) + G.
1
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller abhay. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $5.81. You're not tied to anything after your purchase.
