Economics Study Set 20

Business

Quiz 12 :
Fiscal Policy

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Quiz 12 :
Fiscal Policy

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The government in order to ensure economic growth and stability influence the real variables like output, employment, price level etc. in an economy by adopting either monetary or fiscal policy. A monetary policy influences the variables by changing the money supply and a fiscal policy influences the variables by either changing taxes or the government spending. The crowding out effect is the decrease in private spending due to increase in government spending as a result of a fiscal stimulus in the economy. The proponents of this effect states that the government spending crowds out some or most of the private spending and weaken the effect of fiscal stimulus on aggregate demand. According to the Keynesian thought the government must take an expansionary fiscal policy in recession to direct the economy towards the potential equilibrium. The expansionary fiscal policy is one in which the government either cut the existing tax rate or/and increase the government spending. Both of these will increase government budget deficit. A deficit financed by borrowing will increase interest rate at the loanable funds market and decrease private spending. According to Keynes the crowding out will be less effective in severe recession. In recession even if the government spending is financed through borrowing, the interest will fall to near zero level and the crowding out will likely to be small. According to new classical model, the government deficit will increase future taxes. This increase in future taxes will prompt the individual to save more for the future. The saving of the household will increase the supply of loanable unds market by equal amount and there will be no effect on the interest rate. Hence, the fiscal stimulus will exert no effect on the economy.

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