1. Explain what effect an expansionary fiscal policy would have on the price level and real GDP...

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1. Explain what effect an expansionary fiscal policy would have on the price level and real GDP starting from full employment equilibrium. (4 Marks)2. Why does a larger government budget deficit increase the magnitude of the crowding-out effect? (4 Marks)3. How does the multiplier work and what might government use it for? (5 Marks)4. Explain what effect a contractionary fiscal policy would have on the price level and real GDP starting from full employment equilibrium. (4 Marks)5. What are automatic stabilizers and how do they affect the economy? Which is the most important? (5 Marks)6. Suppose government spending increases in a closed economy. Would the effect on aggregate demand be larger if the Bank of Canada took no action in response, or if the Bank were committed to maintaining a fixed interest rate? Explain (6 Marks)7. In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain (6 Marks) 1. when investment accelerator is large, or when it is small? 2. when the interest sensitivity of investment is large, or when it is small? 3. when the marginal propensity to import is small, or when it is large?8. For various reasons, fiscal policy changes automatically then output and employment fluctuate. (6 Marks) 1. Explain why tax revenue changes when the economy goes into a recession. 2. Explain why government spending changes when the economy goes into a recession. 3. If the government were to operate under as strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe?
	
Document Preview: 1. Explain what effect an expansionary fiscal policy would have on the price level and real GDP starting from full employment equilibrium. (4 Marks)   2. Why does a larger government budget deficit increase the magnitude of the crowding-out effect? (4 Marks)   3. How does the multiplier work and what might government use it for? (5 Marks)4. Explain what effect a contractionary fiscal policy would have on the price level and real GDP starting from full employment equilibrium. (4 Marks)   5. What are automatic stabilizers and how do they affect the economy? Which is the most important? (5 Marks)   6. Suppose government spending increases in a closed economy. Would the effect on aggregate demand be larger if the Bank of Canada took no action in response, or if the Bank were committed to maintaining a fixed interest rate? Explain (6 Marks)   7. In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain (6 Marks) XXXXXXXXXXwhen investment accelerator is large, or when it is small? XXXXXXXXXXwhen the interest sensitivity of investment is large, or when it is small? XXXXXXXXXXwhen the marginal propensity to import is small, or when it is large?   8. For various reasons, fiscal policy changes automatically then output and employment fluctuate. (6 Marks) XXXXXXXXXXExplain why tax revenue changes when the economy goes into a recession. XXXXXXXXXXExplain why government spending changes when the economy goes into a recession. XXXXXXXXXXIf the government were to operate under as strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe?

David · Accepted Answer

1. Explain what effect an expansionary fiscal policy would have on the price level and real GDP starting from full employment equilibrium. (4 Marks)
Since we are full employment level, LRAS intersects AD and SRAS at point E1. with an expansionary fiscal stimulus the AD shifts up to AD2. The new short run equilibrium is at E2. GDP is higher and so are prices. Higher output will cause wages to rise; this will increase the costs of production. The result is that AS will shift upwards till we reach LRAS level. The long run result is that output remains at LRAS level but prices are higher, given by intersection of SRAS2 and AD2. Final equilibrium is at E3. Real GDP remains at LRAS or full employment level.
LRAS
SRAS2
price
SRAS1
E3
E2
                                                                              E1
AD2
AD1
                  GDP
  
 2. Why does a larger government budget deficit increase the magnitude of the crowding-out effect? (4 Marks)
Crowding out refers to a situation where the effect of an expansionary fiscal policy is dampened due to a rise in interest rates which pulls down investment levels. The overall GDP rise= rise due to increase in fiscal expansion –fall in investment level. The rise in interest rates is greater, if the rise in government expenditures in large. When there is a deficit, it means that government expenditures have risen compared to its revenues. The gap between revenues and expenditures is large. Higher is the expenditure, greater is the rise in interest rate and greater is the crowding out effect.  
Deficit/ government spending shifts IS upwards to IS2. This raises GDP and r. the rise in r causes a fall in Investment which causes crowding out and GDP is reduced. The net effect on GDP is shown below. 
LM
r
                                                                                IS2
IS1
GDP
                           Net effect on GDP
   
Crowding out
3. How does the multiplier work and what might government use it for? (5 Marks)
The multiplier concept was given by Keynes. It refers to the change in GDP / income level when any component of aggregate demand changes. This component can be autonomous consumption, investment level, government spending, transfer payment, lump sum taxes, etc, as long as this component is independent of income level. As the name suggests the change in GDP is some ‘multiple’ of the change in autonomous component, so that its value >1 always. Let us say that the government wants GDP to rise by 500. Given a multiplier of 5, it needs to raise its spending by 100 only. The effect will be 5*100 =500 rise in GDP. 
The value of multiplier= 1/ (1-MPC +MPI –MPM) 
= change in GDP / change in autonomous component of AD
where MPC: marginal propensity to consume, 
MPI: marginal propensity to invest, 
MPM: marginal propensity to import. 
4.

1. Explain what effect an expansionary fiscal policy would have on the price level and real GDP starting from full employment equilibrium. (4 Marks) 2. Why does a larger government budget deficit...

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