Question

During 2007-2009, the global economy experienced a severe recession. To deal with recessionary gaps in their economies, many countries implemented expansionary fiscal policies to increase aggregate expenditures. Consider the following hypothetical responses (the actual policies were different in each country).

In 2009, the government of the United States introduced a $675 billion stimulus package - additional government expenditures with no changes to the tax system. In Canada, the tax rate was reduced from 33 percent of GDP to 30 percent of GDP at a cost of $80 billion. Both policies cost about the same nominal dollar value per capita.

QUESTION 1a) (20 Points)

For each country, use the Desired Aggregate Expenditure and Actual National Income framework to illustrate (with a diagram) the impact of each policy on equilibrium expenditure and income. Explain how the government’s new policy alters equilibrium income.

Do a separate illustration for each country. Be sure to label each axis, all equilibrium points and every line or curve. Show the initial equilibrium, show how the policy changed Aggregate Expenditure and show the new equilibrium after the policy was introduced.

QUESTION 1c) (10 Points) Find the new equilibrium GDP (Y) for each country after implementing their expansionary fiscal policies. Show your calculations.

QUESTION 1d) (20 points) Which country chose the wiser policy to deal with a recessionary gap? Use your analysis to justify your answer. Is additional information you would need to help choose which policy option was wiser?

Answer 1

In the scenario of the global crisis, two-country the USA and Canada have taken different measures to overcome it. they have imposed the expansionary fiscal policy. The USA has implemented government spending without any change in tax structure whereas Canada has taken the tax reduction policy. so coming to the USA figure the initial position is the Y=E and before the crisis expenditure c=a+bY, and the equilibrium is E1, income Y* but due to crisis there is an addition in government spending so now there is a shift in expenditure from AE to AE1 now it is C+I. Now the new equilibrium position is E2 with potential income Y1. where Y1 is the effect of government spending with multiplier effect.

In the case of Canada, the initial position is AE, income Y*, Equilibrium point E1, after implementation of tax reduction there is an increase in disposable income with the taxpayer and they will spend it in a different way so there is a shift in aggregate expenditure to AE1, which is C+I and the income will increase from Y* to Y1. this increased income is with the multiplier effect of tax reduction.

In these figures, the new equilibrium points show the changes in income generation. here the amount of investment or the tax reduction as an expansionary policy is less than the income generated the reason behind this is multiplier effect. The multiplier effect says the amount we invest for the development purpose will be multiplied with each fold of transaction.

The new equilibrium quantity of GDP/Income is Y1 for the USA and also Y1 for Canada in both the figure which presents the success of policy implementation.

Between two types of expansionary policies, the USA implied policy is better to compare to tax reduction. When we are putting a extra money in the market that will be more efficient than tax reduction. when there is a tax reduction the increment in disposable income is not always been spent for consumption purposes so the real reason behind the tax reduction could not successfully be implemented. so the governement spending is more efficient then the tax reduction.