Chapter 21, Problem 3CYU

To determine

The country that would experience greater variation in real GDP in response to demand shocks when country B has no unemployment insurance benefits and its tax system uses only lump-sum taxes. Whereas, the neighboring country M has generous unemployment benefits and a tax system in which residents must pay a percentage of their income.

Explanation of Solution

In this case, country B would experience a greater variation in its real gross domestic product as compared to country M due to the following reasons:

1. M country has automatic stabilizers which will provide a mechanism to adjust tax rates and transfer of payments when needed such as increase spending when the economy is slow. Whereas, country B does not involve this automatic stabilizer.
2. Moreover, in country M, the effects of slumps would decrease through unemployment insurance benefits, which will in turn assists the high income of its residents and booms will decrease the income due to high tax rates. But in country B incomes will not be supported in slumps because of the lack of unemployment insurance and benefits in the country.
3. In addition, lump-sum taxes cannot be decreased with the increase in tax revenue which will make country B fails to do so as it has lump-sum taxes. Therefore, in country B, the tax multiplier would be smaller in absolute value when comparing it with the spending multiplier.

Economics Concept Introduction

Introduction: The spending multiplier represents the impact of change in autonomous spending on total spending and demand in the economy of the country, which may increase or decrease.

And, a tax multiplier is used to identify the final increase in the level of real GDP with the change in tax rates.

A lump-sum tax would not increase or decrease with the change in quantity produced in the economy as it remains the same at all levels of output.