Question

Assume the government wants to increase GDP and income Y. It has $100 million to use. Explain why spending it on roads and bridges (government spending G) will increase Y more or less than if it used the money on transfer payments (R) such as welfare payments. You must refer to the multiplier and mathematically why one policy would be different from the other. Explain why one policy would work better than the other.

Answer 1

GDP or Y = C + I + G + NX

C is the consumption expenditure

I is the investment expenditure

G is the government spending

NX is the Net exports which is difference between exports and imports

Increase in spending on roads and bridges increases the G component of GDP and thus increases the GDP or income of a country.

Transfer payments is not included in the estimation of GDP because it does not involve purchase of goods and service while it is just one side transfer to funds by the government to the public.

Multiplier = 1/(1-MPC)

MPC is the marginal propensiy to consume i.e. how much proportion person consume when his income increases marginally.

Change in income = Change in government spending / (1 - MPC)

Transfer payments, R is included in the Consumption function: C = Autonomous consumption + a(Y + R - Taxes)

But change in R does not affect change in income because:

Change in income = Change in Autonomous Consumption / (1 - MPC)