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    Question

    The 'Balanced Budget Multiplier' suggests that an equal

    increase in government spending and taxes will:
    A Have no effect on national income. Correct Answer Incorrect Answer
    B Decrease national income. Correct Answer Incorrect Answer
    C Increase national income by the amount of the spending increase. Correct Answer Incorrect Answer
    D Increase national income by more than the spending increase. Correct Answer Incorrect Answer
    E Decrease national income by the amount of the tax increase. Correct Answer Incorrect Answer

    Solution

    • This is a classic theorem in Keynesian economics.
      • Government Spending Multiplier = 1 / (1 - MPC)
      • Tax Multiplier = -MPC / (1 - MPC)
        If the government increases spending ( Δ G) and taxes ( Δ T) by the  same amount  (so Δ G = Δ T), the net effect on national income ( Δ Y) is the sum of the two multipliers applied to that amount.
        Δ Y = (Spending Multiplier * Δ G) + (Tax Multiplier * Δ T)
        Δ Y = [1/(1-MPC)]* Δ G + [-MPC/(1-MPC)]* Δ T
        Since Δ G = Δ T, we can factor it out:
        Δ Y = Δ G * { [1/(1-MPC)] + [-MPC/(1-MPC)] }
        Δ Y = Δ G * { (1 - MPC) / (1 - MPC) }
        Δ Y = Δ G * 1 =  Δ G
        Hence, national income increases by exactly the amount of the increase in government spending. The multiplier is 1.

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