Question

1. Consider an increase in government spending on roads.

1. Explain which expenditure component of GDP would be most affected.

2. Explain why this an expansionary or contractionary fiscal policy.

3. Explain how this spending may increase economic growth in the long run.

4. Explain what ‘crowding-out’ is using this spending on roads as an example.

2. Provide two reasons to explain why in an ‘economic recession’ the government budget is pushed towards a deficit.

c. Which is more likely to increase GDP by more, a $100 million cut in personal income taxes or an increase in government expenditure by $100 million? Explain why.

Answer 1

Consider an increase in government spending on roads.

1. Explain which expenditure component of GDP would be most affected.

Y = C+I+G+ Net Export

Increase in government expenditure will affect the G components of expenditure.

2. Explain why this an expansionary or contractionary fiscal policy.

Government has increased its expenditure, thus it is an example of expansionary fiscal policy. Increase in government expenditure will cause multiple rise in GDP of country.

3. Explain how this spending may increase economic growth in the long run.

Increase in government spending will cause rise in aggregate demand in economy. Rise in spending would motivate more output of goods and services, so growth rate would inevitably rise.

4. Explain what ‘crowding-out’ is using this spending on roads as an example.

Crowding out effect occurs due to rise in government expenditure which causes rise in interest rate in market. Rise in interest rate induces firms to reduce their investment spending. Such crowding out can be full or partial. Classical economists view that crowding out effect would be full. but keynesian economists do not agree with this.

2. Provide two reasons to explain why in an ‘economic recession’ the government budget is pushed towards a deficit.

First, government is liable to make more expenditure to save economy from further recession. Thus, its deficit rises.

Second, government revenue falls owing to fall in GDP level. Many workers are out of tax bracket when their incomes fall, Eventually government income or revenue fall and deficit moves up.

c. Which is more likely to increase GDP by more, a $100 million cut in personal income taxes or an increase in government expenditure by $100 million? Explain why.

$ 100 million increase in government expenditure is likely to increase GDP more than does the $ 100 million tax cut.

Expenditure multiplier is larger than tax cut multiplier, thus, Expenditure is more effective dealing with recession,