An economy has a budget deficit of $400 billion and a marginal propensity to consume equal to 0.60. To balance the budget the government could decrease government spending by $ _____ billion

The decrease in government spending will decrease output (GDP) by $ _____ billion and therefore tax revenue collected will _____. (Enter whole numbers and then the word increase or the word decrease.)

Will the budget be balanced after this change in government spending? _____ Enter yes or no.

If the budget deficit of the economy is $400 billion and the marginal propensity to consume is 0.6, that means that reducing the budget deficit of $400 billion would reduce consumption by $240 billion. If we consider the model of the simple multiplier, we could define M with the following expression:

• M = 1 / (1 - MPC)

where M is the multiplier and MPC is the marginal propensity to consume.

Then, in this exercise M is equal to:

• M = 1 / 0.4 = 2.5

To sum up, we could say that to balance the budget, the government could decrease spending by $400 billion.

The decrease in spending will decrease total output (GDP) by $1,000 billion and therefore, tax revenue collected will decrease.

If the government reduces the spending in $400 billion, since the reduction in output will reduce the tax collections, the government won't be able to reach the balance of the budget. So, the answer is NO. The budget will not be balanced after this change in government spending. The spending cuts should be much bigger than $400 billion to reach the balance of the budget.