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.
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