Question

Suppose a hypothetical economy is currently in a situation of deficient aggregate demand 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

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

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

a. Tax cuts induce investment spending and improve workers incentives.
b. A dollar in tax cuts immediately and fully adds to aggregate demand.


2. 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. A rise in government spending does not crowd out private sector spending.
b. A rise in government spending completely crowds out private sector spending.

Answer 1

Answer:

1a.Economist A

Government spending multiplier= $8 billion

Tax multiplier=$32 billion

1b.Economist B

Government spending multiplier = $16 billion

Tax multiplier=$8 billion

2a

a. Tax cuts induce investment spending and improve workers incentives.

2b

b. A rise in government spending will tend to completely crowds out private sector spending.

Explanation:

1a.Calculation for Economist A government spending multiplier and tax multiplier

Using this formula

Spending multiplier =Deficient aggregate demand/Government spending multiplier

Tax multiplier =Deficient aggregate demand/Tax multiplier

Economist A

Government spending multiplier =64/8

Government spending multiplier=$8 billion

Tax multiplier=64/2

Tax multiplier=$32 billion

1b.Calculation for Economist B government spending multiplier and Tax multiplier

Economist B

Government spending multiplier =64/4

Government spending multiplier =$16 billion

Tax multiplier=64/8

Tax multiplier=$8 billion

2a. Economist C likely believes that the Tax cuts will induce investment spending and help to improve workers incentives.

2b.Economist D belief that a rise in government spending will completely crowds out private sector spending.