Question

Suppose a hypothetical economy is currently in a situation of deficient aggregate demand of $64 billion....

Suppose a hypothetical economy is currently in a situation of deficient aggregate demand of $64 billion. Four economists agree that expansionary fiscal policy can increase total spending and move the economy out of recession, but they are debating which type of expansionary policy should be used.

Economist A believes that the government spending multiplier is 8 and the tax multiplier is 2. Economist B believes that the government spending multiplier is 4 and the tax multiplier is 8.

Compute the amount the government would have to increase spending to close the output gap according to each economist's belief. Then, for each scenario, compute the size of the tax cut that would achieve this same effect.

Spending Multiplier Tax Multiplier

Policy Options for Closing Output Gap

Increase in Spending Tax Cut
(Billions of dollars) (Billions of dollars)
Economist A 8 2
Economist B 4 8

Economist C favors increases in government spending to tax cuts. This means that Economist C likely believes that:

Government purchases increase aggregate demand by stimulating investment.

Part of a dollar in tax cuts may be saved rather than spent and thus does not fully contribute to aggregate demand.

Economist D argues that it is not possible to move the economy out of recession by increasing government spending. Which of the following statements is consistent with Economist D's belief?

A rise in government spending completely crowds out private sector spending.

A rise in government spending does not crowd out private sector spending.

Homework Answers

Answer #1

(1) Since aggregate demand is deficient by $64B, an expansionary fiscal policy will be chosen to increase aggregate demand (AD) by $64B.

Increase in spending ($B) Tax cut ($B)
Economist A 64 / 8 = 8 64 / 2 = 32
Economist B 64 / 4 = 16 64 / 8 = 8

(2) Economist C likely believes that:

- Part of a tax cut may be saved than spent, and does not fully contribute to aggregate demand

(3) Following statement is consistent with Economist D's belief:

- A rise in government spending completely crowds out private sector spending

[It means that higher government spending raises deficit financing by borrowing, which raises interest rates. Higher interest rate lowers investment by private sector. With complete crowding out, increase in AD caused by higher government spending will be equal to the decrease in AD caused by fall in investment, so net effect on AD is zero]

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