TutorOn by Sanath Withanage

Question:

Which of the following will decrease the Gross Domestic Product by the greatest amount?
(1) Rs. 50 billion increase in both government purchases and taxes
(2) Rs. 50 billion decrease in both government purchases and taxes
(3) Rs. 50 billion increase in taxes
(4) Rs. 50 billion decrease in government purchases
(5) Rs. 50 billion increase in net exports

Correct Answer:

(4)

Answer Explanation:

A decrease in government spending reduces GDP directly via the spending multiplier (e.g., $1/(1-MPC)$). An increase in taxes reduces GDP via the tax multiplier, which is always smaller than the spending multiplier (e.g., $-MPC/(1-MPC)$). Therefore, a direct cut to government purchases will always shrink the economy by a mathematically greater amount than an equivalent tax hike.

Topic: Fiscal Policy Year: 2018