Question

2. Assuming Ricardian equivalence holds, how much would current consumption fall as a result of a one unit increase in government spending, assuming this increase did not affect the real interest rate? What is then the total impact on the demand for goods?

3. Explain in words what the partial expenditure multiplier measures? What does it equal to assuming Ricardian equivalence holds? What about when Ricardian equivalence does not hold?

Answer 1

Answer to question no 2 :- When the government spending increases , it can finance the higher spending by :-

1) Increasing Taxes

2) Increasing borrowing

IMPACT OF HIGHER GOVERNMENT SPENDING ON DEMAND :-

1) Increased Taxes :- When government finances it's spending by charging higher taxes then it will reduce the discretionary income of the consumer , lowering the consumer spending. Therefore the aggregate demand does not increase because rise in government spending is offset by fall in consumer spending.

2) Increased borrowing- If government increases it's borrowing , it will sell bonds to the private sector . If the private sector buys these bonds , they will make no private sector investment .Therefore it brings stagnancy in the private sector instead of increasing the aggregate demand .

Answer to question no 3 :-

Fiscal deficits in the economy requires issuing of public debt .Thus there is a notion of a partially balanced multiplier to achieve the desired stimulus in GDP with least possible effect on public debt .

Basically the notion of imperfect balanced multiplier is based on the idea that simultaneous increase in public revenue and expenditure can boost GDP , keeping the public deficit unchanged.

This kind of policy was implemented in Spain .