Question

In a closed economy, a government sees its role growing with the economy, i.e.

GY=g0+g1Y, where g₀> 0 and 0 <g₁< 1.

(a)     Solve for the equilibrium level of income and derive the income multiplier.

(b)     Analyze the effects of an increase in the autonomous component of public spending on the economy when (i) wages and prices are fixed; (ii) wages and prices are flexible.

Answer 1

A). The equilibrium on the goods market implies that Y = c0 + c1(Y –T) + g0 – g1G or Y = 1/(1 – c1 + g1)*(c0 + g0 – c1T)The Keynesian multiplier is 1/(1 – c1
+ g1) which is smaller than 1/(1-c1). The positive impact of an increase in autonomous
spending is partially offset by the subsequent drop in government spending.

B) The Keynesian theory suggested that government spending program is just to provide a short-term boost to help overcome a recession or depression like- situation in the economy. They even suggested that policymakers should be ready to reduce government spending once the economy is recovered so as to prevent inflation, which they believed would result from too much economic growth.

However, if the deficit is out of control it can pose a problem for the economy. Our Indian economy is mostly in deficit and in some years it has become uncomfortably high. Some of the consequences of the high Fiscal Deficit are as follows-

1. High inflation

2. High interest rate

3. High taxes in some cases

There is a high possibility that the rise in taxes will negate the impact of rising government spending which would leave Aggregate Demand (AD) unchanged. However, it is possible that increased spending and rise in tax could lead to an increase in GDP.

Multiplier effect

Fiscal Multiplier is often seen as a way that spending can boost growth in the economy. This multiplier state that an increase in the government spending leads to an increase in some measures of economic wide output such as GDP.

Flexible price

The neoclassical view of how the macroeconomy adjusts is based on the insight that even if wages and prices are “sticky”, or slow to change, in the short run, they are flexible over time.

decrease in aggregate demand leads to a recession. Over time, though, wages will fall, shifting aggregate supply to the right, bringing prices down as well. This process continues until equilibrium returns

with full employment. Similarly, an increase in aggregate demand leads to an inflationary gap, causing wages to increase over time until the aggregate supply curve shifts to the left, raising prices and returning equilibriuma and full employment.

In both cases, aggregate demand changes have no long run effect on real GDP or employment, but only on wages and prices. This is what neoclassicals believe.