Question

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is: a. The worst possible combination of tax and expenditure changes. b. The best possible combination of tax and expenditure changes. c. A mediocre and contradictory combination of tax and expenditure changes. d. None of the above. After selecting your responses to both questions explain your answers in detail, use economic terms (aggregate-spending, production, income, employment...What are the economic consequences, how would they influence the four major sectors (C+I+G+Xn) and Real GDP.

Answer 1

Ans Option C

An increase in government expenditure is a fiscal expansion and  will lead to an increase in induced consumption leading to increase in aggregate demand and for given aggregate supply it will lead to an increase in price level and output. But an increase in tax rate to pay for increased government expenditure is a fiscal contraction which is an opposite policy to fiscal expansion. So, increased taxes decrease disposable income of the households causing consumption to fall, this will lead to a decrease in aggregate demand and price level will come down and output will contract. Thus, if fiscal contraction is less than the size of fiscal expansion then the increase in output will be low in comparison to only fiscal expansion. Hence, it is a mediocre and contradictory combination of policies.

Assuming that fiscal expansion is more than contraction, consumption will increase causing IS curve to shift rightwards this will lead to increase in interest rate which will lead to crowding out of private investments due to increased cost of borrowing. This increase in interest rate will make domestic economy attractive to foreign investors, so, net capital outflow will decrease and domestic currency will appreciate. This will make exports costlier and imports cheaper, increasing the net exports. Overall consumption will increase, government expenditure will increase, private investment will decrease and net exports will decrease and overall affect of all this is increased real GDP leading to increase in employment which will lead to increase in price level. All this is under the assumption that government spending has increased more than the tax revenue has increased

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