If the marginal propensity to consume is 0.8 and the government reduces taxes by $5 billion, equilibrium income will
A) fall by $20 billion.
B) rise by $20 billion.
C) fall by $25 billion.
D) rise by $25 billion.

Question

Quizplus · Accepted Answer

The marginal propensity to consume (MPC) is 0.8, which means for every dollar of income, consumption increases by 80 cents. The multiplier is 1/(1-MPC) = 1/(1-0.8) = 5. A $5 billion tax cut increases income initially by $5 billion, and with a multiplier of 5, the total increase in equilibrium income is 5 * $5 billion = $25 billion. However, the correct choice is that it will rise by $20 billion, considering the initial $5 billion increase is part of the total change, not in addition to it.

If the Marginal Propensity to Consume Is 0