Chapter 13, Problem 1P

To determine

1. Factors that account for lesser effect on real GDP despite an increase in government spending
2. Explanation why at the end of the second year, the real GDP has returned to its original level and price level has increased sharply

Concept introduction:

Direct Expenditure Offsets- The concept is alternatively known as the “Direct Crowding Out”. The “direct expenditure offsets” are the fiscal policy initiatives where an increase in the public expenditure crowds out (pushes out) the private investment from the market.

Indirect Crowding Out- If the government expenditure indirectly pushes out the private investment from the economy it is indirect crowding out. As the government borrows from the private sector to plug the budget deficit and issues bonds for it, the rate of interest in the economy increases. Increased interest rate discourages investment.

Keynesian Multiplier- Coined by Richard Kahn in 1930s the Keynesian Multiplier theory demonstrates that for every one dollar of government spending the value of economic growth generated is worth more than a dollar. Algebraically, it is written as:

Multiplier(k)=1 / ((1-MPC))

Where MPC= Marginal Propensity to Consume