Question

FILL IN THE BLANK: (The size of the blank has nothing to do with the answer)

1. The _____ propensity to consume is the change in _____ from a one unit increase in aggregate income or output

2. When a country has a stabilization________ it will use Keynesian fiscal stimulus whenever real GDP was expected to fall short of the full ___________ output level.

3. The _________ out effect occurs when government borrowing leads to higher _________ rates and lower
private sector consumption and investment.

Answer 1

1. The marginal propensity to consume is the change in consumption from a one unit increase in aggregate income or output.

The Keynesian consumption function is given by

C = a + b_{​​​​​​}​​​​​Y_​​​ a >0 0< b <1

Here C is the consumption, Y​​​​​​​​​​​​​​​​​ is the income .

The parameter b measure the marginal propensity to consume. Here b= () is positive implying a positive relationship between income and consumption and lies between 0 and 1 implying that the consumer does not consume the entire increment in income, a part of the additional income is saved. The parameter 'a' is the intercept term and measure consumption at 0 level of income.

2. When a country has a stabilization policy it will use Keynesian fiscal stimulus whenever real GDP was expected to fall short of the full employment output level.

Keynes proposed fiscal stimulus whenever the economy was stuck in a recession or output was below it's full employment level. Here the approach was to raise government spending financed by government borrowing. This increases the private savings and better utilises the unused resources which helps the economy to recover. Here the aggregate demand is not too low yet the economy is below its full capacity and can remain there for a long time, thus a push is needed to bring the economy to its full employment level.

3. The crowding our effect occurs when government borrowing leads to higher interest rates and lower private sector consumption and investment.

An increase in government spending or government debt is often financed by raising new debt. The increase in government borrowing raises the interest rate due to increase in demand for loans, this increase in interest rate lowers private sector investment as people are demotivated to borrow due to higher interest rate. Hence here we see in the IS-LM model that an increase in government borrowing is accompanied with decline in private investment. Since private investment is a component of aggregate output or aggregate income, a decrease in private investment reduces the aggregate output or total income. This leads to a reduction in aggregate consumption. This is known as the crowding out effect as the increase in government borrowing crowds out private borrowing and because of this a situation may arise where equilibrium interest rate rate increases and equilibrium output is less than before.