Suppose that the government increases expenditures by $150 billion while increasing taxes by $150 billion. Suppose that the MPC is .80 and that there are no crowding out or accelerator effects. What is the combined effects of these changes? Why is the combined change not equal to zero?
The multiplier is 1/(1-MPC) = 1/(1-.8) = 1/.2 = 5 . The increase of $150 in government expenditures leads to a shift of $150 billion x 5 = $750 billion in aggregate demand. The increase in taxes decreases income by $150 and so initially decreases consumption by $150 billion x MPC = $150 billion x .8 = $120 billion. This change in consumption will create a multiplier effect of $120 billion x 5 = $600 . Thus the net change is $750 billion - $600 billion = $150 billion. The changes don't cancel each other out because a tax increase decreases consumption by less than the tax increase.
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