Question

State and local governments are facing historic budget shortfalls as a result of the Covid-19 pandemic. Many economists argue that one of the most effective measures the Federal government can take is to offer financial assistance to state and local governments. Explain the economic rationale behind their recommendation. Use economic concepts and reasoning.

Answer 1

The COVID19 has indeed put the world economy in crisis. Companies aren't able to run efficiently, consumer demand has fallen because of the lockdown, unemployment is on a high. The governments are running shortfalls in their budgets and economists are advocating expenditure on the part of the Federal government. The economic rationale behind this advice is to increase the Aggregate Demand in the economy.

The Keynesian AD comprises of 4 components primarily:

AD = Consumption + Investment + Government Expenditure + Net Exports

Now, in this time of crisis, consumers aren't demanding, thus consumption is suppressed. Businesses aren't seeing a bright light either and aren't undertaking investments. The entire world economy is suffering which keeps the net exports also low. Hence, the only way out of this poor AD economy is expenditure by the government.

The government would give money to local governments who would use it to hire private services and infrastructure, thus putting money into the economy and creating demand. This will propagate in the entire economy with an amplified effect which is the Keynesian "multiplier effect". And, subsequently pull the economy out of low AD.

Graphically, thus can be represented as:

An increase in government expenditure by delta G, shifts AD rightwards to AD2. The real GDP also increases by delta Y.

Thanks!