Question

1.In the Keynesian Cross model, why does a $1 increase in government purchases increase national income by more than $1? How does this result compare with the effect of a $1 increase in government expenditures in the long-run model of loanable funds? Why do the results differ?

2.The government increases government purchases and taxes by the same amount. Consider the following statement: “Since the entire increase in government expenditures is funded through new taxes, there is no crowding out of investment associated with this policy in the long-run.” Is this statement true or false? Explain.

Answer 1

1) In the Keynesian Cross model a $1 increase in government purchases increase national income by more than $1 is because of the multiplier process. It is the process by which an increase in autonomous expenditure leads to a larger increase in real GDP. An initial increase in government expenditure leads to a series of induced increased in consumption. It increases aggregate demand and national income and thereby leading to further increase i induced spending.

In the loanable fund market, increase in government expenditure leads to increased demand for loanable funds. There is excess of borrowers over lenders at the initial interest rate and thus the interest rate is pushed up. Rise in interest rate causes savings to increase and also caues the quantity of investment to fall. The amount of decrease in consumption, which equals the amount of increase in savings and decrease in investment just equals the amount of increase in the government spending. So, the increase in government expenditure financed by selling bonds to the public pushes the rate of interest up by enough to crowd out an equal amount of private expenditure.