Fiscal policy Suppose a hypothetical economy is currently in a recessionary gap

Question

Fiscal policy Suppose a hypothetical economy is currently in a recessionary gap 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 4. Economist B believes that the government spending multiplier is 4 and the tax multiplier is 2. 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. Economist C favors increases in government spending to tax cuts. This means that Economist C likely believes that: Part of a dollar in tax cuts may be saved rather than spent and thus does not fully contribute to the aggregate demand. Government purchases increase aggregate demand by stimulating investment. Economist D argues that it is not possible to remove the economy from the recessionary gap by increasing government spending. Which of the following statements is consistent with Economist D's belief? A rise in government spending does not crowd out private sector spending. A rise in government spending completely crowds out private sector spending.

Explanation / Answer

(1) To close the gap, GDP should increase by $64 billion.

(a) Economist A

If Spending multiplier = 8, it means that if government spending increases by $1, GDP will increases by $8.

So, to increase GDP by $64 billion, spending should increases by $64 billion / 8 = $8 billion.

If tax multiplier = 4, it means that if tax is cut by $1, GDP increases by $4.

So, to increase GDP by $64 billion, tax should be cut by $64 billion / 4 = $16 billion.

(b) Economist B

If Spending multiplier = 4, it means that if government spending increases by $1, GDP will increases by $4.

So, to increase GDP by $64 billion, spending should increases by $64 billion / 4 = $16 billion.

If tax multiplier = 2, it means that if tax is cut by $1, GDP increases by $2.

So, to increase GDP by $64 billion, tax should be cut by $64 billion / 2 = $32 billion.

(2) Economist C most likely believes that, a portion of the tax cut (which raises disposable income) goes towards saving and not consumption, therefore the tax cut will but completely contribute to aggregate demand.

(3) Rise in government spending completely crowds out private spending.

As government raises spending, it incurs budget deficit which is normally financed by borrowing. Higher borrowing will increase interest rate which will dampen investment demnd, therefore investment demand is crowded out.

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