Question

1. Explain using a macroeconomic equation of the GDP, how government can use fiscal policy to stimulate the economy?

Answer 1

Suppose, the macroeconomic equation of the GDP is as follows:

GDP = consumption (C) + Investments (I) + government spending (G) + net exports

Or

GDP = C + I + G + NX

To stimulate the economy, fiscal policy is used and as a  part of fiscal policy, government spending increases.

The increase in government spending causes G to increase to the level of G'.

Further, the spending causes firms to increase the supply and it creates jobs and employment increases. People getting employed, consume more and consumption increases. Besides, there is a multiplier effect that is given by:

Spending multiplier = 1/(1-MPC)

MPC is the marginal propensity to consume and it tells the portion of a dollar spent by people when it is earned by them. It further creates demand and economy is stimulated.

The complete multiplier effect, causes C to increase to the level of C'.

Now,

New GDP = C' + I + G' + NX

Here, New GDP is higher than the GDP and it is the result of fiscal policy, involving increase in government spending.