Suppose that the government increases its expenditure on goods and services by $100 billion and pays for these goods and services by raising autonomous taxes by $100 billion. What is the effect on aggregate demand and real GDP of each change individually and of the two combined?

 

Increase of government expenditure on goods and services by $100 billion.

This would result to an increase in the aggregate demand and real GDP With more than $100 billion. This is because of the expenditures multiplier which causes the effect of government expenditures to be more than the expenditure itself. For example, if the expenditures multiplier is 2.5, then an expenditure of $100 billion would result to an increase in real GDP and aggregate demand by $250 billions ($100*2.5)

Raising autonomous taxes by $100 billion

This would result to a decrease in the real GDP and aggregate demand but with a lesser value than $100 billion. This is as a result of tax multiplier effect. Foe example, If the government raises the autonomous taxes by $100 billion and having a tax multiplier of 0.8, then the real GDP and aggregate demand will decrease by $80 billion ($100 billion*0.8)

Combined increased expenditure of $100 billion and raised autonomous taxes by %100 billion

This would result to increased GDP and aggregate demand with a value of more than $100 billion. This is because the expenditures multiplier is always bigger than the tax multiplier

Taking on our example, government expenditure would cause an increase by $2.5 billions and raised autonomous taxes cause a reduction by $80 billion. So the final impact will be an increase in real GDP and aggregate demand by $170 billion, ($250 billion-$80 billion).