Question

Which of the following is true of the multiplier: A) It is larger or higher than 1 when unemployment is below the natural rate of unemployment. That is government is spending increases or tax decreases have less effect when the economy is doing well. B) It is smaller or below 1 when unemployment is below the natural rate of unemployment. That is government spending increases or tax decreases have less effect when the economy is doing well. C) It is larger or higher than 1 when unemployment is below the natural rate of unemployment. That is government spending increases or tax decreases have less effect when the economy is doing worse. D) It is below or less than 1 when unemployment is below the natural rate of unemployment. That is government spending increases or tax decreases have greater effect when the economy is doing well.

Answer 1

The correct answer is Option (B) It is smaller or below 1 when unemployment is below the natural rate of unemployment. That is government spending increases or tax decreases have less effect when the economy is doing well.

Explanation -

When the unemployment rate is below the natural rate of unemployment, the economy is already at potential output or in an inflationary gap. In such a scenario, the impact of higher government spending or lower taxes on the economy is lower. Since the economy is already producing at or higher than the potential output. The excess liquidity in such a scenario can manifest in the form of higher prices than an increase in "Real Output." On the other hand, when the economy is below or well below potential output, the impact of lowering taxes or increasing government spending is much more. In other words, the multiplier is higher than 1. Since there is ample headroom to increase the output to potential output.