The marginal propensity to consume is 0.8 and taxes are lump-sum. The government raises its purchases of goods and services by Rs 60 crore and raises lump-sum taxes by Rs 40 crore. What is the change in equilibrium income?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → A rise of Rs 140 crore
A rise in government purchases works through the government expenditure multiplier, 1 ÷ (1 − c). A rise in lump-sum taxes works through the tax multiplier, −c ÷ (1 − c), which is negative.
Given:
c = 0.8
ΔG = 60
ΔT = 40 (Rs crore)
\( \displaystyle \text{Government expenditure multiplier} = \frac{1}{1 - 0.8} = 5 \)
\( \displaystyle \text{Tax multiplier} = \frac{-0.8}{1 - 0.8} = -4 \)
\( \displaystyle \Delta Y = 5 \times 60 - 4 \times 40 = 300 - 160 = 140 \)
Income rises by Rs 140 crore. The two multipliers are different: the tax multiplier is one less in absolute value, because a tax change acts only through disposable income and consumption.
Option (2) A rise of Rs 20 crore — this applies the balanced budget result to the net change, but the budget is not balanced here.
Option (4) A rise of Rs 300 crore — this leaves out the tax rise.
NCERT (2026-27): “Box 5.1: Fiscal Policy … Because a tax cut (increase) will cause an increase (reduction) in consumption and output, the tax multiplier is a negative multiplier. Comparing equation (5.6) and (5.8), we find that the tax multiplier is smaller in absolute value compared to the government spending multiplier. This is because an increase in government spending directly affects total spending whereas taxes enter the multiplier process through their impact on disposable income, which influences household consumption (which is a part of total spending). …” “Within the present framework, if we take different values of the marginal propensity to consume and calculate the values of the two multipliers, we find that the tax multiplier is always one less in absolute value than the government expenditure multiplier. …” |