Given the necessary increase in GDP of $500 and the MPC of $0.90, how much should we reduce the taxes to get GDP to its natural state?

Answer 1

To determine the amount by which taxes should be reduced to increase GDP by $500, we can use the spending multiplier formula, which is equal to 1 / (1 - MPC).

The spending multiplier determines how much a change in autonomous spending (such as tax reduction) can affect GDP.

In this case, the MPC is given as 0.90, meaning that for every additional dollar of income, people spend 90% and save 10%.

To calculate the spending multiplier, we can use the formula:

Spending Multiplier = 1 / (1 - MPC)
= 1 / (1 - 0.90)
= 1 / 0.10
= 10

Now, we know that the desired increase in GDP is $500. By using the spending multiplier, we can determine the amount of tax reduction required to achieve this increase:

Tax Reduction = Desired Increase in GDP / Spending Multiplier
= $500 / 10
= $50

Therefore, to get GDP to its natural state with the given increase of $500 and an MPC of 0.90, we should reduce taxes by $50.