The marginal propensity to consume out of permanent income equals 0.9 and the marginal propensity to consume out of transitory income equals 0.1. Suppose that there is an emergency increase in government spending of $200 billion to repair infrastructure.
The spending takes place within a year. The spending increase is financed by a one-time increase in taxes. Prior to the increase in government spending, permanent income equals $9,600 billion and transitory income equals zero.
(a) Compute the amounts of consumption expenditures and private saving prior to the tax increase.
(b) Compute the amount of changes in consumption expenditures and private saving, given that the tax increase lasts for only one year.
(c) Compute the initial change in aggregate demand that results from this combination of increases in government spending and taxes.