Quiz 28: Managing Aggregate Demand: Fiscal Policy

Business

Budget deficit Budget deficit refers to the higher government expenditure than the government revenue. Gross domestic product (GDP) GDP refers to the total value of goods and services produced in the country during a period of time. a. Impact of larger budget deficit on the GDP The higher defense spending causes higher budget deficit. When the United States spends higher amount for the defense, it leads to an increase of investment on army goods and services in the United States. This increase in investment leads to an increase in output and employment, which in turn increases the GDP. b. Impact of unchanged government expenditure on the GDP When the total government purchases remain unchanged, the government investment remains unchanged. Since the government investment remains the same, there is no change in employment and output. Hence, there would be no change in GDP.

In Table (2), the GDP of an economy equals to consumption expenditure when both are at $1,720; hence, the equilibrium level of GDP is $1,720. Graphical presentation of equilibrium level of GDP In Figure (1), GDP is measured on horizontal axis and consumption expenditure is measured on vertical axis. img Figure - 1 The above figure explains that the consumption expenditure and GDP obtain equilibrium at img when both values are at $1,720 and intersects the 45-degree line. The marginal propensity to consume (MPC) explains the increase in personal consumption per increase in additional amount of disposable income. The marginal propensity to consume can be calculated using the following formula: img ……(1) The following table presents marginal propensity to consume using the formula in Equation (1). Table - 3 img Fifth column of Table (1) shows the marginal propensity to consume is $0.75. The consumption multiplier can be calculated using the following formula: img ……(2) Using Equation (2), calculate the multiplier: img The result reveals that if 75 percent of the income is consumed, then its multiplier effect on income will be 4 percent. Since the multiplier effect of consumption is 4, the reduction in government purchases by $60 will reduce the consumption expenditure by $240 img .

Investment multiplier Investment multiplier refers to the change in the income level due to the change in the level of investment. Government expenditure multiplier Government expenditure multiplier refers to the change in the income level due to change in the level of government expenditure. Tax multiplier Tax multiplier refers to the change in the income level due to change in the level of tax. Reasons for government expenditure multiplier being same as investment multiplier The government expenditure is equal to the investment. When government purchases goods and services from the private, then the investment of the private firms would increase. Since the government expenditure directly affects the investment, the government expenditure has the same multiplier as caused by the investment. Reasons for tax expenditure multiplier being different from expenditure multiplier The expenditure multiplier directly increases the income through increasing the level of investment, whereas the tax multiplier affects the income level through consumption, which alters the investment. The level of consumption depends on the marginal propensity to consume. This change in the tax does not affect the marginal propensity to consume. Hence, the tax multiplier is not same as government multiplier.

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