In an economy with a government, C = 20 + 0.75Yd, where Yd = Y − T is…

In an economy with a government, C = 20 + 0.75Y_d, where Y_d = Y − T is disposable income. Investment is 30 and government expenditure is 40 (all figures in Rs crore). If taxes rise from Rs 40 crore to Rs 60 crore, what happens to equilibrium income?

Answer & explanation

Correct answer: option 3

The correct answer is Option (3) → It falls by Rs 60 crore

Taxes lower disposable income, so consumption falls by c times the rise in tax. That fall in spending then works through the multiplier.

Given:

C = 20 + 0.75(Y − T), I = 30, G = 40

Equilibrium: Y = 20 + 0.75(Y − T) + 30 + 40, so Y = (90 − 0.75T) / 0.25

With T = 40: Y = (90 − 30) / 0.25 = 60 / 0.25 = 240

With T = 60: Y = (90 − 45) / 0.25 = 45 / 0.25 = 180

Fall in income = 240 − 180 = Rs 60 crore

The quick way: autonomous spending falls by 0.75 × 20 = 15, and the multiplier is 1/0.25 = 4, so income falls by 4 × 15 = 60.

Option (1) It falls by Rs 80 crore — Incorrect. This multiplies the whole tax rise of 20 by 4. Only 0.75 of the tax comes out of spending.

Option (2) It falls by Rs 20 crore — Incorrect. This is the tax rise itself, with no multiplier.

Option (4) It falls by Rs 15 crore — Incorrect. This is the first fall in consumption (0.75 × 20), before the multiplier works.

NCERT (2026-27): “4.2 Determination of Income in Two-sector Model … At this point, we can introduce a government in this economy. The major economic activities of the government that affect the aggregate demand for final goods and services can be summarized by the fiscal variables Tax (T) and Government Expenditure (G), both autonomous to our analysis. Government, through its expenditure G on final goods and services, adds to the aggregate demand like other firms and households. On the other hand, taxes imposed by the government take a part of the income away from the household, whose disposable income, therefore, becomes Yd = Y – T. Households spend only a fraction of this disposable income for consumption purpose. Hence, equation (4.3) has to be modified in the following way to incorporate the government Y = C̄ + Ī + G + c (Y – T ) Note that G – c.T , like C or I , just adds to the autonomous term A .”