Deficit spending (a higher government spending for a given tax rate) appears to have a negative...

Deficit spending (a higher government spending for a given tax rate) appears to have a negative effect on the economy but in the IS-LM model we can see that the opposite is true. A higher G increases the GDP by enhancing demand. Which one do you think is true? Can you reconcile these two ideas? What is your conclusion in terms of practical policy?

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Expert Solution

Deficit spending by the government illustrates that government is resorting to borrowing to fund its expenditure. Borrowing by government raises interest rate in market. Rise in interest rate discourages private investment. Thus, such negative effects might be severe in some cases which eventually end up effecting economy negatively.

But the IS-LM model shows something otherway, There is negative effects of deficit spending but these effects do not erode away positive effects of government spending. Positive effects of government spending are larger than the negative effects of deficit spending.

It can be illustrated with help of diagram:

In above diagram,

Full effect of government spending are between Y1 and 2.

But due to rise in interest rate, there is fall in private investment,

So economy moves to Y3 but still economy is witnessing rise in GDP which equal to Y1 and Y3.

Rahul Sunny answered 7 months ago

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