Question By late 2009, Greece\'s national debt had grown so large relative to th

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Question By late 2009, Greece's national debt had grown so large relative to the size of its economy that lenders had lost confidence in the Greek government's capacity to service it. Fear of a Greek default led to contagion -Spain, Italy, Portugal, and Ireland were all subject to the disapproving glare of frightened lenders. The crisis caused seismic disruption in Europe and the rest of the world. The International Monetary Fund, the European Commission, and the European Central Bank reluctantly offered Greece bail-out loans- but with strings attached. In order to get the money, Greece had to agree to austerity measures. In this context, austerity means tight fiscal policy - that is, higher taxes and/or lower government spending in order to shrink Greece's annual budget deficit. Using your knowledge of the impact of the government's budget on the equilibrium level of real GDP, and your understanding of the effect of the economy on the state of the government's budget, explain why austerity measures usually result in less improvement in the government's budget position than policymakers had hoped for. Be sure to define what we mean by 'the government's budget.

Explanation / Answer

The government budget reflects the annual financial statement presenting proposed spending and revenue.

Austerity measure is fiscal measure taken by the government to control the public sector debt, i.e., when the debt become so large to get default these measures are taken to control it. These measures are taken to reduce the gap between government spending and revenue. Austerity measures are taken by two ways: first is to increase taxes to increase govenment revenue and second is to reduce expenditure.

Increasing taxes is usually not favoured by incumbents when economy is already doomed as greece economy in our case. So, reduction in govenment spending seems to be the fisible measure to be taken to reduce public debt. But, austerity measure can further worsen the government budget because, fiscal policy is an instrument to government to stimulate demand in the economy during economic downturn, if government reduces its spending then it would lead to fall in aggregate demand which would increase the unemployment rate, with the increasing unemployment rate, would result in fall in taxes in next economic year and less taxes means less government revenue. Again lower budget means further reduction in demand. This vicious cycle of worsening government budget would result in long term economic recession.

From above we can clearly state that, austerity measures leads to fall in aggregate demand or GDP which result in fall in government budget and that fall in government budget would futher reduce the aggregate demand.

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