Question

2. The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is:
a. The worst possible combination of tax and expenditure changes.
b. The best possible combination of tax and expenditure changes.
c. A mediocre and contradictory combination of tax and expenditure changes.
d. None of the above.

After selecting your responses to both questions explain your answers in detail, use economic terms (aggregate-spending, production, income, employment...What are the economic consequences, how would they influence the four major sectors (C+I+G+Xn) and Real GDP.

Answer 1

c. A mediocre and contradictory combination of tax and expenditure changes.

An increase in spending is an expansionary policy, where government spending will increase the G component of GDP, so this will increase the aggregate spending and outcome. Raising tax is a contractionary policy, it will make consumers consume less since disposable income falls and will also disincentivize them to work, thus leading to a fall in C. Also due to less private savings, I will also fall. So, output will fall. Thus, they are contradictory changes.