2. Fiscal policy Suppose a hypothetical economy is currently in a recessionary g

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2. Fiscal policy

Suppose a hypothetical economy is currently in a recessionary gap of $64 billion. Four economists agree that expansionary fiscal policy can increase total spending and move the economy out of recession, but they are debating which type of expansionary policy should be used.

Economist A believes that the government spending multiplier is 8 and the tax multiplier is 2. Economist B believes that the government spending multiplier is 4 and the tax multiplier is 8.

Compute the amount the government would have to increase spending to close the output gap according to each economist's belief. Then, for each scenario, compute the size of the tax cut that would achieve this same effect.

Policy Options for Closing Output Gap

Economist C favors tax cuts over increases in government spending. This means that Economist C likely believes that:

- Tax cuts induce investment spending and improve workers incentives.

- A dollar in tax cuts immediately and fully adds to aggregate demand.

Economist D argues that it is not possible to remove the economy from the recessionary gap by increasing government spending. Which of the following statements is consistent with Economist D's belief?

- A rise in government spending does not crowd out private sector spending.

- A rise in government spending completely crowds out private sector spending.

Spending Multiplier Tax Multiplier

Policy Options for Closing Output Gap

Increase in Spending Tax Cut (Billions of dollars) (Billions of dollars) Economist A 8 2 Economist B 4 8

Explanation / Answer

Government needs to fill gap of $64 billions

for economist A

Tax multipler is 2 so to fill a output gap of 64 billions, cut taxes by 64/ 2 = 32 billion

tax have to cut by $32 billions

govt spending multiplier is 8, so spendinh has to increase by 64/8=$8 billions.

for economist B

Tax multipler is 8 so to fill a output gap of 64 billions, cut taxes by 64/ 8= 8 billion

tax have to cut by $8 billions

govt spending multiplier is 4, so spending has to increase by 64/4=$16 billions.

c. This means that Economist C likely believes that:

- Tax cuts induce investment spending and improve workers incentives.This is because cutting the taxes gives an incentive to the workers to work more.

d. A rise in government spending completely crowds out private sector spending, because increased govt spending increases the interest rate, hence private spending is crowded out.

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