Question

Suppose a student who has not taken economics asks you why economists are arguing

that we need a “fiscal stimulus package.” How would you answer this question? (better if typed please)

Specifically,

a) Why are economists arguing that government spending is the solution to this

problem? Use Y=C+I+G to answer this question. Why can’t we increase C or I

instead of G?

b) Why might an economist recommend infrastructure spending over tax cutes?

c) Suppose the spending package is 500 billion dollars. Graphically illustrate

using AD/AS curves the initial impact of an increase of spending of 500 billion.

Also, assume that the MPC is .5. Calculate the multiplier, and the total impact on

the economy. Make sure to graphically illustrate the full multiplier effects on your

AD/AS graph.

d) Explain the lags of fiscal policy. Why might these lags prevent fiscal policy

from being effective?

Answer 1

(a) Y = C + I + G, it is the aggregate demand in the closed economy in which we does not include the net exports in it. Fiscal stimulus is the increasing government expenditure for increasing infrastructure in the economy or lowering taxes in the economy to raise welfare. Now the topic comes why they just raise G part of it not C / I, because it does not matter whether C / I / G , every component of the AD shifts it to the right. If government wants to shifts AD, they can increase any one of it. Assume a condition if there is recession in an economy and government wants to raise output level in the economy. In recession consumers cannot raise the consumption level in any case because they have less income in recession due to low market growth. Investment also cannot be raised because during recession we have less demand in the economy, raising investment level in the economy would have no impact on raising the output because there would be consumer to buy the product. Government always have enough money to spend on their country in difficult phases, so they raise only G to raise output level.

(b) If government wants to lower the taxes there can be case that government have enough reserves with them, they wants to lower the burden on public by cutting taxes. Economist recommend to government to not to reduce the taxes but they can raise the infrastructure spending while will also lower the reserves of them. Raising the infrastructure in the economy would raise the welfare in the economy which can make people happy and they would pay the tax without any problem if they getting equally benefits by paying the taxes.

(c) If MPC = .5, it means that the change in consumption by 250 by raising output by $500 billion.

(d) Lags in Fiscal Policy are the time taken by the policy to being effective in the market. Lets say Government raised expenditure to increase out and it took 6 months to pass the bill. Once the bill passed after 6 months, it took another year to build infrastructure needed. Meanwhile the world is affected by recession, due to which government needs to stop spending and started reducing spending level. There could be implementation phase too which can affect affect fiscal policy and reduce its efficiency.