Suppose the government, in an effort to avoid an increase in the deficit, votes for a budget neutral tax cut policy. Assume the marginal propensity to consume (MPC) is equal to 0.85 and taxes are cut by $8 billion. Round answers to the nearest billion, and specify decreases as a negative number.
A. By how much will government spending change?
B. What is the resulting change in the equilibrium level of real GDP?

PART A:

The government has voted for budget neutral tax cut policy in order to avoid the enhancement in the deficit. Thereby, government spending will be reduced by an amount of $8 billion.  

PART B:

The calculation for fall in GDP is as follows:  

Multiply with change in government expenditure,

Thus, if the government expense is reduced by $8 billion then fall in GDP is by $53.33 billion  

EFFECT ON GDP DUE TO REDUCTION OF TAX:

Multiply with change in tax,

Thus, when the taxes are reduced by $8 billion, then GDP shows an increase by $45.33 billion.

Therefore, change in equilibrium level of real GDP = -$8 billion ( -53.33 billion + 45.33 billion).  

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