Question

In an attempt to stimulate the economy, the Union Government announced a \(\$ 23.9\) billion increase in its planned expenditure in the annual budget. Source: CNBC, March 19, 2015 If the slope of the \(A E\) curve is \(0.6,\) calculate the immediate change in aggregate planned expenditure and the change in real GDP in the short run if the price level remains unchanged.

Short answer

The immediate change in aggregate planned expenditure is \( 23.9 \text{ billion} \). The change in real GDP is \( 59.75 \text{ billion} \).

Step-by-step solution

Identify and define the given values

The problem statement provides the following values: 1. Increase in government expenditure: \( 23.9 \text{ billion} \) 2. Slope of the aggregate expenditure (AE) curve: \( 0.6 \)

Calculate the immediate change in aggregate planned expenditure

The immediate change in aggregate planned expenditure due to a change in government expenditure is directly equal to the change in government expenditure. Therefore, the immediate change in aggregate planned expenditure is \( 23.9 \text{ billion} \)

Calculate the change in real GDP using the multiplier effect

The change in real GDP is determined using the spending multiplier formula: \( \text{Multiplier} = \frac{1}{1-\text{Slope of AE curve}} \). Given that the slope of the AE curve is 0.6, \[ \text{Multiplier} = \frac{1}{1-0.6}=2.5 \]. The change in real GDP is then calculated by multiplying the initial increase in government expenditure by the multiplier: \[ \text{Change in real GDP} = \text{Increase in government expenditure} \times \text{Multiplier} \]. \[ \text{Change in real GDP} = 23.9 \text{ billion} \times 2.5 = 59.75 \text{ billion} \]

Key concepts

government expenditure

Government expenditure refers to the amount of money that a government spends on goods, services, and public projects. This spending can serve several purposes, including:

• Stimulating economic growth
• Providing public services such as education, healthcare, and infrastructure
• Redistributing income to promote social welfare

When the government increases its expenditure, like the \(23.9\) billion increase mentioned in the exercise, it injects money directly into the economy. This spending can boost demand, create jobs, and stimulate further economic activities. When calculating the impact of this increase, we first look at its direct effect on aggregate planned expenditure.

aggregate expenditure

Aggregate expenditure (AE) is the total spending on goods and services in an economy at a given overall price level and in a given period. It includes:

• Consumer spending
• Government expenditure
• Investment by businesses
• Net exports (exports minus imports)

In our example, the government announced a significant increase in its planned spending. This increase means that the aggregate expenditure curve will shift upwards by the amount of this new spending. With a slope of the AE curve at 0.6, the rise in government expenditure directly translates into immediate changes in overall spending in the economy, impacting the overall economic activity.

multiplier effect

The multiplier effect occurs when an initial change in spending (such as government expenditure) leads to a more significant overall change in income and output. In economic terms, the spending multiplier is calculated using the formula:
\[ \text{Multiplier} = \frac{1}{1 - \text{slope of AE curve}} \]
In our case, with the slope of the AE curve at 0.6, the multiplier is calculated as follows:
\[ \text{Multiplier} = \frac{1}{1-0.6} = 2.5 \]
This multiplier tells us that every dollar of initial government spending generates an additional 2.5 dollars of economic activity. Thus, an increase of \(23.9 \text{ billion}\) in government expenditure will multiply and result in a total increase of \(59.75 \text{ billion}\) in real GDP.

real GDP

Real Gross Domestic Product (GDP) measures the value of all goods and services produced in an economy, adjusted for inflation. It is a critical indicator of economic health. When we talk about changes in real GDP, we imply the actual growth in economic activity, excluding price level changes. The exercise shows how the increase in government expenditure results in a rise in real GDP by leveraging the multiplier effect. Specifically, an initial government spending boost of \(23.9 \text{ billion}\) will translate into a \(59.75 \text{ billion}\) increase in real GDP, given the calculated multiplier of 2.5. This rise reflects true growth in economic output without being skewed by inflation or price increases.