Suppose now the economy is in recession and the government wishes to increase Y

Question

Suppose now the economy is in recession and the government wishes to increase Y by $400 billion. This is a close economy with following consumption function C=co+0.75(Y-T) Tis a lump-sum tax and the private investment (I) is given as constant. In reality, government can adopt different fiscal policies to increase Y by $400 billion. For example, it can i) increase government spending (G), on ii) cut tax (T) or ii) increase G and T by same amount (so called the balanced budget policy The government spending multiplier isl/ MPC) 4, the tax multiplier is -MPC/ MPC)3, and the balanced-budget multiplier, as always, is l Given the information above, please fill in the following table on these three policies and their impacts on government deficit. a) Required Change Impact orn Government Deficit Policy Options Multiplier 1. Increase G 2. Decrease T 3. Increase G and T by equal amoun 4 Which policy the government usually prefers? Explain your answer. (8 marks) b) Suppose there is no change in I as assumed, please evaluate the impact of above three policies you designed on C and G

Explanation / Answer

a) We know that change in Y / Change in autonomous value = Multiplier

1) The desired change in income is 400 billion. Hence the required increase in G is 400/4 = 100

billion.

2) Now taxes are to be reduced. Required reduction is 400/-3 = -133.33 billion

3) Now multiplier is 1, G and T should both be increased by 400 billion. This will increase Y by 400*4 =

1600 billion and reduce it by 400*3 = 1200 billion so that at the end Y increases by 400 billion

In case of strong fiscal complexicities and burgeoning fiscal deficits, balanced budget is also used. But

mostly it is budget spending that is curtailed or expanded.

b) 1) When G rises, income rises and so consumption also rises. Hence both C and G are increased.

2) When T is reduced, only C is increased as more disposable income is now available

3) In this case Y increases by the amount of increase in G so only G increases and not C.

First policy is better because it brings the economy out of recession more quickly than the other strategies. Multiplier effect is strongest in this case.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.