What is the effect on savings of a tax cut of 10billion? Is this inflationary or deflationary? Assume that the marginal propensity to consume is \(0.85\)

The relationship between disposable income (income after taxes), consumption, and savings can be represented as follows: Disposable income = Consumption + Savings If taxes decrease, disposable income will increase. The increase in disposable income will be spent on consumption and savings according to the marginal propensity to consume (MPC).

Given that the tax cut is 10 billion, the change in disposable income can be calculated as: ΔDisposable income = -ΔTaxes = 10 billion

The MPC is the ratio of the change in consumption to the change in disposable income. We are given that the MPC is 0.85, which implies that when disposable income increases, 85% of the increase will be spent on consumption, and the remaining 15% will be spent on savings. ΔConsumption = MPC × ΔDisposable income ΔSavings = (1 - MPC) × ΔDisposable income Plugging in the values, we get: ΔConsumption = 0.85 × 10 billion = 8.5 billion ΔSavings = (1 - 0.85) × 10 billion = 1.5 billion

An increase in consumption can lead to an increase in aggregate demand, which may cause inflation (if the economy is operating near full capacity) or reduce unemployment (if there is slack in the economy). On the other hand, an increase in savings can lead to an increase in investments, which might have a positive long-term effect on the growth of the economy. If ΔConsumption is greater than ΔSavings, then there is a higher chance for the tax cut to be inflationary, as people are spending more instead of saving. In this case, since ΔConsumption (8.5 billion) is greater than ΔSavings (1.5 billion), we can determine that the tax cut is more likely to be inflationary. However, the actual effect on inflation depends on the current state of the economy and other factors, such as the monetary policy and the output gap. For example, if the economy operates below full capacity, an increase in private consumption could be beneficial to close the output gap without causing significant inflation.