Question

Explain the impact of government expenditures on the equilibrium level of income. How does this differ from the effect of changes in taxation? What is the multiplier?

Answer 1

ans.....
According to the Keynesian cross model, the equilibrium level of national income (Y*) is achieve where the consumption function intersects the 45-degree line. At this point, all income that is generated is consumed. For an open economy, the aggregate demand is given by:
Y = AD = C + I + G + (X-M)
Increase in government expenditure (G) will lead to an increase in national income through increases in wages, consumption, savings, investment, imports and exports. The overall impact will be a rightward shift in the AD and AS curves to establish a new equilibrium level of national income.
* Suppose the government only spends and doesn’t collect tax revenue would mean that the entire public expenditure is financed by deficit financing or money creation. The government earns income in the form of taxes. An increase in taxes reduces disposable income and are assumed to be exogenous. Since consumption is a function of disposable income and taxes reduce consumption. In effect, the aggregate demand schedule shifts downward and equilibrium level of income declines.
* Every time there is an injection of new demand into the circular flow, there is likely to be a multiplier effect. Multiplier is the factor by which gains in total output are greater than the change in spending that caused it. Keynes created the equation C = bY and I = Y-C, where b is referred as marginal propensity to consume. Keynes rearranged the equation to solve for income, or Y=1/(1-b) and redefined Y as ‘k,’ writing k = 1/(1-b). Keynes referred ‘k’ as the multiplier. For any new injection of government spending, ‘k’ showed the relationship between change in income (dY) and change in investment (dI), or dY = k*dL.