Chapter 37, Problem 1FT

Subpart (a):

To determine

Multiplier and impact on GDP.

Explanation of Solution

The initial increase in government spending leads to increased income and consumption. This is because, the increased government spending leads to more investment, thus increasing the aggregate demand and therefore the output. This would further increase income and consumption and hence there is an overall increment in the National Income which is greater than the initial increase in spending. Hence the multiplier tends to be greater than one during this time. Thus greater the multiplier, the net effect is an increase in the GDP.

There is also a possibility that if the economy tends to be at full capacity, the increased government spending may tend to crowd out the private sector, resulting in no net increase in aggregate demand thus no net effect on GDP.

Economics Concept Introduction

Concept introduction:

GDP (Gross Domestic Product): GDP refers to the market value of all final goods and services that are produced in an economy during an accounting year. It is equated as $\text{GDP}=\text{Consumption (C)}+\text{Investment (I)}+\text{Government expenditure}\text{}\text{ (G)}+\text{Net export}$.

Multiplier: Multiplier refers to the ratio of change in the real GDP to the change in the initial consumption at a constant price rate. Multiplier is positively related to the marginal propensity of the consumer and negatively related to the marginal propensity to save.

Crowding out: Crowding out effect refers to the decrease in the availability of money for private investment due to increase in the fiscal expansion.

Aggregate demand (AD): Aggregate demand refers to the total value of the goods and services that are demanded at a particular price in a given period of time.

Subpart (b):

To determine

Multiplier and impact on GDP during recession.

Explanation of Solution

During a recession, the growth rate is negative. The multiplier is estimated to be lower during recession. In such a situation the increased government spending can stimulate the economy. It is also possible that the increased spending may create a multiplier effect which causes the unemployed to attain job, hence income leading to an increase in aggregate demand. This can result into a final increase in GDP than the initial injection.

Economics Concept Introduction

Concept introduction:

GDP (Gross Domestic Product): GDP refers to the market value of all final goods and services that are produced in an economy during an accounting year. It is equated as $\text{GDP}=\text{Consumption (C)}+\text{Investment (I)}+\text{Government expenditure}\text{}\text{ (G)}+\text{Net export}$.

Multiplier: Multiplier refers to the ratio of change in the real GDP to the change in the initial consumption at a constant price rate. Multiplier is positively related to the marginal propensity of the consumer and negatively related to the marginal propensity to save.

Aggregate demand (AD): Aggregate demand refers to the total value of the goods and services that are demanded at a particular price in a given period of time.