The marginal propensity to consume is 0.8 and taxes are lump-sum. The government raises transfer payments by Rs 50 crore and cuts its purchases of goods and services by Rs 40 crore. What happens to equilibrium income?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → It does not change.
Transfers reach spending only through consumption, so the transfer multiplier is c ÷ (1 − c). Government purchases are spending in full, with the multiplier 1 ÷ (1 − c).
Given:
c = 0.8
ΔTR = +50
ΔG = −40 (Rs crore)
\( \displaystyle \text{From transfers: } \frac{0.8}{0.2} \times 50 = 4 \times 50 = 200 \)
\( \displaystyle \text{From purchases: } \frac{1}{0.2} \times (-40) = 5 \times (-40) = -200 \)
\( \displaystyle \Delta Y = 200 - 200 = 0 \)
Income does not change. The two multipliers are not the same: the transfer multiplier is 4 and the government purchases multiplier is 5, because a part of every transfer is saved.
Option (1) It rises by Rs 50 crore. — this applies the multiplier 5 to the net change of 10.
Option (2) It rises by Rs 40 crore. — this applies the multiplier 4 to the net change of 10.
NCERT (2026-27): “Box 5.1: Fiscal Policy … Transfers: We suppose that instead of raising government spending in goods and services, government increases transfer payments, TR̄. Autonomous spending, Ā, will increase by cΔTR̄, so output will rise by less than the amount by which it increases when government expenditure increases because a part of any increase in transfer payments is saved. …” |