CFA Level IEconomicsMedium
An economy has a marginal propensity to consume (MPC) of 0.80 and a proportional income tax rate of 25%, which acts as an automatic stabilizer. If the government increases spending by $200 billion, what is the resulting change in equilibrium GDP?
- A$500 billion
- B$800 billion
- C$1,000 billion
- D$250 billion
Show answer & explanationAnswer & explanation
Correct answer: A. $500 billion
With a proportional tax, the spending multiplier is 1/[1-MPC(1-t)] = 1/[1-0.80(0.75)] = 1/[1-0.60] = 1/0.40 = 2.5. Applying this to the $200 billion spending increase gives ΔGDP = 200 × 2.5 = $500 billion. The tax rate reduces the multiplier relative to the no-tax case (which would be 1/(1-0.8)=5), illustrating how automatic stabilizers dampen fiscal impact.
Why the other options are wrong
- B. Incorrect—this equals 200×4, not the correct multiplier.
- C. Incorrect—this uses the multiplier without accounting for the tax stabilizer.
- D. Incorrect—this understates the multiplier effect.
Automatic Stabilizer (Tax-Adjusted Multiplier)
Progressive/proportional taxes reduce the size of the fiscal multiplier because a portion of additional income is taxed away, lowering the marginal propensity to spend out of GDP.
- Multiplier = 1/[1-MPC(1-t)]
- Higher tax rate t reduces multiplier size
- Automatic stabilizers smooth business cycle swings without new legislation
Memory trick: Taxes act like a shock absorber, softening every spending bump.