PROBLEMS All problems are assignable in MyEconLab. Answers to odd numbered probl

Question

PROBLEMS All problems are assignable in MyEconLab. Answers to odd numbered problems appear in MyEconLab 13-1. Suppose that Congress and the president decide that the nation's economic performance is weaken- ing and that the government should "do s thing" about the situation. They make no tax changes but do enact new laws increasing govern- ment spending on a variety of programs. a. Prior to the congressional and presidential action, careful studies by government econo- mists indicated that the Keynesian multiplier effect of a rise in government expenditures on equilibrium real GDP per year is equal to 3. In the 12 months since the increase in government spending, however, it has become clear that the actual ultimate effect on real GDP will be less than half of that amount. What factors might account for this? b. Another year and a half elapses following pas- sage of the government spending boost. The government has undertaken no additional policy actions, nor have there been any other events of significance. Nevertheless, by the end of the second year, real GDP has returned to its origi- nal level, and the price level has increased sharply. Provide a possible explanation for this outcome.

Explanation / Answer

The government finances its spending either by an increase in taxes or an increase in borrowing. In this case, as the Congress and the President make no tax changes, we will analyse the impact of increase in government borrowings on the GDP. In an attempt to increase its spending, the government borrows from the private sector by selling bonds to the private sector. They could be private individuals, pension funds or investment trusts. However, if the private sector buys these government securities/bonds they will not be able to use their money to fund private sector investment. Thus, the government crowds out the investment of private sector. The term 'crowding out' describes how an increase in government borrowing can increase the interest rates of the bonds and inturn of the economy. These higher interest rates have a discouraging effect on the private sector investment and spending. Therefore, an increase in G (government spending) is somewhat offset by a fall in I (investment) and the overall effect on real GDP is less than the anticipated multiplier effect.

With the continued government spending boost, the crowding out effect leads to an increase in interest rates and consumers tend to save more because of a higher return on savings. This results in a decrease in C (consumption) as the personal expenditure goes down and the aggregate demand decreases further reaching its original level of real GDP. However, this process also leads to a leftward shift (decreade) of the aggregate supply curve due to fall in output as producers cut back on their production due to a decrease in C (consumption). Thus, by the end of second year, real GDP returns to its original level, but the price level increases sharply.

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.