Question

Suppose that Congress and the president decide that the nation's economic performance is weakening and that the government should "do something" about the situation. They make no tax changes but do enact new laws increasing government spending on a variety of programs.

a. Prior to the congressional and presidential action, careful studies by government economists indicated that the Keynesian multiplier effect of a rise in government expenditures on equilibrium real GDP per year is equal to $3$. In the $12$ months since the increase in government spending, however, it has become clear that the actual ultimate effect on real GDP will be less than half of that amount. What factors might account for this?

b. Another year and a half elapses following passage of the government spending boost. The government has undertaken no additional policy actions, nor have there been any other events of significance. Nevertheless, by the end of the second year, real GDP has returned to its original level, and the price level has increased sharply, Provide a possible explanation for this outcome.

Short answer

a, In the near run, real GDP rises, but not by the full amount promised by the multiplier effect.

b, As a result, by the end of the second year, real GDP had reverted to its initial level, while prices had risen dramatically.

Step-by-step solution

Introduction (part a)

The given is about the decision made for the actions to be done by the government for the weakening nation's economy

The objective is to determine the factors that account for this situation

Explanation (part a)

a,

a,

The basic reason for the actual eventual effect on real GDP is lower than increased government spending is the crowding-out effect. As you may be aware, the government's expansionary fiscal policy, which raises interest rates and hence cuts investment spending, causes the crowding-out effect.

In this area, the government has increased spending but not lower taxes. As a result of the indirect crowding out effect, when the government sold bonds to support its expenditures, private spending fell.

Furthermore, increased government expenditure improves aggregate demand, which leads to price increases. This will have a long-term impact on consumer behavior. This could detract from a consumer's desire to save money in order to spend less. In the short run, real GDP rises, but not to the full extent that the multiplier effect promises.

Introduction (part b)

The objective is to determine the factors that account for this situation and to provide a possible explanation for the outcome

Explanation (part b)

b)

As you are aware, the government's increased spending has resulted in an increase in total expenditure. As a result, in the long run, salaries and other input prices are likely to climb in lockstep with price rises.

As a result, government spending just raises the price level, which boosts salaries and other input costs in the long run. As a result, real GDP had reverted to its original level by the end of the second year, although prices had risen considerably.