Consider an economy in a recessionary gap. The government plans to pursue a fisc
ID: 1167333 • Letter: C
Question
Consider an economy in a recessionary gap. The government plans to pursue a fiscal expansion by increasing the amount it spends on purchasing (G).
a. Discuss the pros and cons of using a fiscal expansion rather than allowing the market to self-correct.
b. Given that the government decides to pursue the expansion, discuss what sorts of economic activities (i.e. public-sector investment vs. public-sector consumption) the government should spend on and why. In your discussion, be sure to address the immediacy and duration of the effects on GDP.
Explanation / Answer
a. Pros of using fiscal expansion rather than allowing the market to self correct :
Can Direct Spending To Specific Purposes :
Unlike monetary policy tools, which are general in nature, a government can direct spending toward specific projects, sectors or regions to stimulate the economy where it is perceived to be needed to most.
Can Use Taxation to Discourage Negative Externalities :
Taxing polluters or those that overuse limited resources can help remove the negative effects they cause while generating government revenue.
Short Time Lag :
The effects of fiscal policy tools can be seen much quicker than the effects of monetary tools.
cons of using a fiscal expansion rather than allowing the market to self-correct :
Can Create Budget Deficits :
A government budget deficit is when it spends more money annually than it takes in. If spending is high and taxes are low for too long, such a deficit can continue to widen to dangerous levels.
Tax Incentives May Be Spent on Imports :
The effect of fiscal stimulus is muted when the money put in to the economy through tax savings or government spending is spent on imports, sending that money abroad instead of keeping it in the local economy.
May Be Politically Motivated :
Raising taxes is unpopular and can be politically dangerous to implement.
b. We know that, if any element of the C + I + G + (Ex - Im) formula increases, then GDP—total demand—increases. If the “G” portion—government spending at all levels—increases, then GDP increases. Similarly, if government spending decreases, then GDP decreases.
Public sector is better for government.
Private firms have a profit incentive to cut costs and develop products demanded by consumers. In the government sector, this profit motive is often absent. Therefore government bodies have a greater tendency to be overstaffed and inefficient in private sector.