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Macroeconomic fiscal policy choices

Macro-economic choices, particularly in the areas of fiscal policy, are not just about economics but about political philosophies, values and goals. This Case asks you to think about some of these dimensions.

1. Do all government purchases have the same effect on aggregate demand? Defend your answer with economic reasoning.

2. Suppose a country increases government purchases by $100 billion. Suppose the multiplier is 1.5 and the economy's real GDP is $5,000 billion.

a. In which direction will the aggregate demand curve shift and by how much?

b. Why is the change in real GDP is likely to be smaller than the shift in the aggregate demand curve?

3.
a. What is "crowding out," and how does it reduce private investment?

b. Given that only certain types of government expenditures crowded out private investment, what are the implications for fiscal policy choices

Solution Preview

A good overview of this entire topic can be found here:

http://faculty.washington.edu/danby/notes/notes910.html

1. Do all government purchases have the same effect on aggregate demand? Defend your answer with economic reasoning.

Government purchases which directly go into goods and services do the most to stimulate the economy. Those which go to pay government workers have less of an impact. This is due to the marginal propensity to save (MPS). In other words, government workers do not spend all of what they earn - they save some of it, and that part of it doesn't increase aggregate demand. Likewise, a reduction in taxes may not affect aggregate demand as direct spending, due to the taxpayers tendency to save some of the tax rebate. Only if they spend all of it will the tax decrease have the same effect as a government purchase.

Read more: Fiscal Policy and ...

Solution Summary

How fiscal policy can be best used to stimulate the economy, as supported by economic theory.

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