Question

1. Suppose the government plans to stimulate the economy in a specific year. One policy would cut taxes and government expenditures by the same amount: $50 billion. Another policy would give businesses a temporary investment tax credit of 15% on each productive investment project. Which policy would be more successful in stimulating the economy? Explain.

2. How does inventory investment (planned and unplanned) change during recessions and booms? Explain.

Answer 1

1) A tax cut by 50 will have positive effect on gdp as it increases disposable income which further increases consumption spending by less than 50. But simultaneous decrease in government spending by 50 will decrease gdp by more than tax cut increases the gdp. Thus the overall effect on gdp is negative.

15% investment tax credit reduces the investment cost which results in increasing investment in the economy. Increase in investment has positive effect on gdp.

Thus investment tax credit is successful in stimulating the economy.