Question

2. Fiscal policy

Suppose a hypothetical economy is currently in a situation of deficient aggregate demand of $16 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 4 and the tax multiplier is 2. Economist B believes that the government spending multiplier is 2 and the tax multiplier is 8.

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.

	Spending Multiplier	Tax Multiplier	Policy Options for Closing Output Gap
			Increase in Spending	Tax Cut
			(Billions of dollars)	(Billions of dollars)
Economist A	4	2
Economist B	2	8

Economist C favors tax cuts over increases in government spending. This means that Economist C likely believes that:

Tax cuts induce investment spending and improve workers’ incentives.

A dollar in tax cuts immediately and fully adds to aggregate demand.

Economist D is skeptical about the effectiveness of an increase in government spending as an expansionary fiscal policy. Which of the following statements is consistent with Economist D's belief?

How government spends money is less crucial to the success of policy than the magnitude of government spending.

The specifics of how the government spends money are crucial to the effectiveness of an expansionary policy.

Answer 1