Question

Assume that policy makers pass a budget that calls for an increase in government spending. In an open economy, which of the following will occur as a result of this fiscal policy action? Select one: a. Private saving increases. b. Investment decreases. c. The current account worsens. d. Either A or C occurs. e. Either A, B, or C occurs.

Answer 1

Answer:(d) Either A or C

Either Private savings increases or the current account worsens, here's why;

When government spending increases, it essentially means that the government allocates funds into projects and investment that benefit the society as well as improve private and government income. Say the government spends money into constructing a public sector held bread factory. The funds that are spent in the construction of the factory are the income of several people who are associated with the construction of the same project. Thus these people's individual / private income is expected to increase. Also, after the construction of the factory is complete, the government is expected to employ a number of people into it's operations from production, distribution, marketing etc and the income of these people rise as well.

Thus, in general when government spending rises,  private income is also expected to rise along with private savings and private investments and so does rise the aggregate demand for goods and services. Thus with the increase in government expenditure, private savings increases as a result.

At times, there is a current account deficit as a result of excess government spending. A current account is part of a nation's Balance of payments, which shows all current nature transactions ( one way / unilateral transactions). A current account ends up in a deficit when there are more current transactions PAID than current transactions RECEIVED.

A current account may end up in a deficit as a result of bad and unplanned government spending. Governments allocate funds for the purpose of being spent for various needs of the nation. Many a times, these needs can be on those avenues where the economic productivity returns are low and do not contribute much towards overall productivity or towards the GDP.

Say government increases it's spending for acquiring defense equipments and financing military expenses or it spends a lot of money on unemployment aid and other poverty alleviation schemes, where the returns to productivity is low. Expenditure such as this do not contribute much in return towards overall economic productivity and thus increases the deficit in the government's current account.

Thus the possibilities of increased government spending could either be an increase in private savings or the current account worsens