During the recent recession, when countries around the world suffered high unemp
ID: 1230456 • Letter: D
Question
During the recent recession, when countries around the world suffered high unemployment rates and the governments were experiencing huge budget deficits, economists debated whether to raise or cut taxes or to raise or cut government spending. Many argued that the governments could raise taxes on certain income groups and, at the same time, increase spending to give a boost to the economya) Let us consider a hypothetical example to examine the merit of this argument. Assume that an economy was in liquidity trap and its initial GDP was 10,000 billion dollars and the marginal propensity to save was 10%. Assume away the foreign trade sector. How much would be the change in income (GDP) if the government increased both spending and taxes by 20 billion dollars?
b) Do you expect the same result to hold in the standard model where the IS curve and the LM curve are of normal shapes? Explain.
Explanation / Answer
The role of government in the American economy extends far beyond its activities as a regulator of specific industries. The government also manages the overall pace of economic activity, seeking to maintain high levels of employment and stable prices. It has two main tools for achieving these objectives: fiscal policy, through which it determines the appropriate level of taxes and spending; and monetary policy, through which it manages the supply of money. Much of the history of economic policy in the United States since the Great Depression of the 1930s has involved a continuing effort by the government to find a mix of fiscal and monetary policies that will allow sustained growth and stable prices. That is no easy task, and there have been notable failures along the way. But the government has gotten better at promoting sustainable growth. From 1854 through 1919, the American economy spent almost as much time contracting as it did growing: the average economic expansion (defined as an increase in output of goods and services) lasted 27 months, while the average recession (a period of declining output) lasted 22 months. From 1919 to 1945, the record improved, with the average expansion lasting 35 months and the average recession lasting 18 months. And from 1945 to 1991, things got even better, with the average expansion lasting 50 months and the average recession lasting just 11 months. Inflation, however, has proven more intractable. Prices were remarkably stable prior to World War II; the consumer price level in 1940, for instance, was no higher than the price level in 1778. But 40 years later, in 1980, the price level was 400 percent above the 1940 level. In part, the government's relatively poor record on inflation reflects the fact that it put more stress on fighting recessions (and resulting increases in unemployment) during much of the early post-war period. Beginning in 1979, however, the government began paying more attention to inflation, and its record on that score has improved markedly. By the late 1990s, the nation was experiencing a gratifying combination of strong growth, low unemployment, and slow inflation. But while policy-makers were generally optimistic about the future, they admitted to some uncertainties about what the new century would bring.
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