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Question
Consider an economy described by the following functions:- C = 20 + 0.80Y, I = 30, G = 50, TR = 100, calculate the effect on output of a 10 per cent increase in transfers, and a 10 per cent increase in lump-sum taxes. Compare the effects of the two.
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Solution
MPC = 0.80
`barC` = 20
I = 30
G = 50
TR = 100
ΔTR = 10
Equilibrium level of income `=1/(1-c)[barC+cTR+I+G+DeltaTR]`
`=1/(1-0.80)[20+0.80xx100+30+50+0.80xx10]`
`=188/0.20xx100="Rs." 940`
Change in income = 940 − 900 = Rs 40
Increase in lump-sum tax ΔT =10
Change in Income `=DeltaT(-c)/(1-c)`
`=-10xx0.80/0.20`
= -10 × 4
=-40
From the above results, we can conclude that increase of 10 percent in transfers will raise the income by 40%.
And, increase of 10% in tax will lead to a fall in the income by 40%.
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