The marginal propensity to consume is 0.8 and taxes are lump-sum. The government raises its purchases by 100 and pays for them with an equal rise in lump-sum taxes. Once all the rounds have worked out, what happens to income and to consumption?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Income rises by 100; consumption does not change
Spending and taxes rise by the same amount, so the balanced budget multiplier of 1 applies.
Given:
c = 0.8
ΔG = ΔT = 100
\( \displaystyle \Delta Y = 1 \times 100 = 100 \)
\( \displaystyle \Delta Y_{D} = \Delta Y - \Delta T = 100 - 100 = 0 \)
\( \displaystyle \Delta C = 0.8 \times 0 = 0 \)
Income rises by the full 100. Disposable income does not change, so there is no induced consumption.
Option (1) Income rises by 500; consumption rises by 400 — Incorrect. This counts only the rise in spending (5 × 100). The tax cuts income by 400, which leaves a net rise of 100.
Option (2) Income does not change; consumption falls by 80 — Incorrect. Income does rise: the tax works only through consumption, so it lowers income by less than the spending raises it.
Option (4) Income rises by 100; consumption rises by 80 — Incorrect. Consumption rises only if disposable income rises, and here it does not.
NCERT (2026-27): “Box 5.1: Fiscal Policy A balanced budget multiplier of unity implies that a 100 increase in G financed by 100 increase in taxes increases income by just 100. This can be seen from Example 1 where an increase in G by 100 increases output by 500. A tax increase would reduce income by 400 with the net increase of income equal to 100. The equilibrium income refers to the final income that one arrives at in a period sufficiently long for all the rounds of the multipliers to work themselves out. We find that output increases by exactly the amount of increased G with no induced consumption spending due to increase in taxes. …” |