Answer: (B)
Compared to the first economist, the second economist must be assuming either a smaller induced increase in consumption, a larger crowding out effect, or both.
Explanation:
First of all, I'll like to explain some terms:
- Government Expenditure Multiplier is an index or figure showing the percentage by which Gross domestic product (GDP) will increase, when Government Expenditure increases; all other kinds of expenditure held constant
- the GDP equation is
GDP= C + I + G + (X-M)
Where C = consumption expenditure (by individuals)
I = investment expenditure (by firms)
G = government expenditure
(X-M) = international trade (export-import) expenditure
- If we hold other independent variables constant and measure the government expenditure multiplier, we will derive the index that shows the amount by which an increase in G will increase GDP.
Now to the question;
Crowding out effect means an act by the government to purchase so much more domestic goods and services than they previously purchased.
This is done deliberately by the government for various reasons: to boost the economy, to provide social welfare goods, and to kick-start national projects.
It is called "crowding out" because these huge government purchases limit private sector purchases.
If the 2nd economist assumes a larger crowding out effect, that means greater government expenditure, then this rhymes with the higher GM (government expenditure multiplier) that his estimate produces. GM of 1.25 means that a percent increase in G will increase GDP by 25%.
On the other hand, Economist 1's estimate of 0.75 implies a 25% decrease in GDP (coming from a decrease in G), which explains his part of option B. He (economist 1) is assuming a lesser crowding out effect.
If we add the assumption of Economist 2 that there'll be smaller induced increase in consumption, it follows that C will have a less positive impact on GDP.
If we combine both changes in C and G, we also have G producing more increase in GDP.
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