Question

Imagine you are a policy maker confronted with the options of increasing government expenditures (G) versus lowering taxes (T) in the same amount during a recession. Which alternative would you support and why? Answer briefly with one or two paragraphs.

Answer 1

One of the great economists John Keynes has advocated the role of the government of fiscal measures to stimulate the economy in the recessionary times. The classical economics prefers minimum intervention by the government in the economy but Keynes argued that prices tend to be sticky in the short term and that is why they do not adjust quickly according to the economic condition and so that government should intervene in the economy. It can raise its expenditure or cut the taxes to stimulate the economy. These two options are always debated for the net effect on the economy.

a) The lowering the taxes is somewhat populist approach as it directly affects the consumers. They feel that the outgo from the tax is lower and having a higher level of disposable income could increase spending in the economy. The multiplier effect because of tax cut is affected by the MPC or marginal propensity to consume and MPS that is known as marginal propensity to save.

Tax Cut Multiplier = MPC / MPS

This is a simple form of the multiplier effect of the tax cut. So if the MPC is 0.75 then obviously MPS will be 0.25 and the multiplier value will be 3 in this case. A tax cut of $100 billion will result in $300 billion positive effect on the economy.
100 * (0.75 / 0.25) = 300

b) The government expenditure also stimulates the economy as it the increased expenditure means the people can realize income in the form of wages or profit. This also increase disposable income but the multiplier effect is only affected by the MPC or marginal propensity to consume.

Expenditure Multiplier = 1 / (1 - MPC)
So if the MPC is again 0.75 then the multiplier value is 4 and an increase of government expenditure by $100 billion will result in a positive effect of $400 billion on the economy.
100 * (1/(1-0.75)) = 400

So raising government expenditure has a more positive effect on the economy than the tax cut. It is obvious that the option of increasing the government expenditure should be adopted.