FISCAL POLICY

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

The government buys a part of the final services and goods produced by the economy. The purchase of these goods and services by the government is what is termed as government purchases. Government purchase entails those expenditures that purchase the final goods and services, which also amounts to the gross domestic product. All government purchases do not amount to the total government spending. Some of government spending specifically on transfer payments, such as welfare and social security, are not part of government purchases.

All the three levels of government are important–federal, state, and local. While a lot of attention is understandably focused on the federal level in the study of macroeconomics, federal government purchases are only about one-third of the total. Any government purchase can cause an increase in aggregate demand. Most government purchases lead to increased government contracts to those in the private industry (Arnold, 2008).

This ends up facilitating increased  HYPERLINK “https://www.boundless.com/economics/definition/consumption/” consumption, employment and increased wages. Governments are able to influence the economy by using fiscal policy to determine the shift of aggregate demand. This is usually done when trying to achieve the objectives of full employment, price stability and economic growth.

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.

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

The aggregate demand curve will shift to the right. This is due to the fact that Treasury will sell much more bonds than would have otherwise been sold were the purchases lower. Why is the change in real GDP likely to be smaller than the shift in the aggregate demand curve?

The effect of increased government purchases is a deficit or reduction in surplus. When government purchase decreases, the aggregate demand decreases, hence shifting to the left.

From the Case in Point ‘Crowding Out in Canada’ in Section 12.3, and answer the following:

a. What is “crowding out,” and how does it reduce private investment?

Crowding out is that which reduces how effective any expansionary fiscal policy is. All this may be the increase of transfer payments, the increase of government purchases or the reduction in income taxes. Every one of these policies results in an increase in the deficit and thus an increase in government borrowing. This spurs the increase in supply of bonds, a rise in interest rates, a rise in exchange rates, investment falls and a fall in net exports.

As an expansionary fiscal policy can either result in an increase in government spending or reduce revenues, it further increases the deficit in government budget or reduces the surplus. Fiscal policy is what affects the bond market. An analysis of monetary policy will show that changes in the bond market may directly affect net exports and investment. The ultimate result from an expansionary fiscal policy is an increase in the amount of government purchases (Dwivedi, 2010).

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

When the private investment is crowded out, then the expansionary fiscal policy may take the form of increased investment element of government purchases. Some of government purchases, as earlier noted, are goods. These goods may be office supplies and or services. The government can however purchase investment items too. These include schools and roads. In such a case, the government investment can be said to be crowding out the private investment.

At the contractionary fiscal policy is where a reverse of crowding out can be sad to occur. This is where there is a cut in transfer payments, of government purchases or cases of tax increases. Policies of that kind increase the surplus or reduce the deficit. This reduces government borrowing while shifting the supply curve to the left. When interest rates then drop, there is a facilitation of a larger quantity of investment. These lower interest rates also cause a reduction in the demand for dollars which boosts net exports and lowers the exchange rate. This is called “crowding in.”

The effect of fiscal policy is clearly weakened by crowding in and crowding out. Economists have given arguments that these forces are powerful enough such that a varying fiscal policy gets to have no result on aggregate demand. The level of crowding out as well as crowding in still remains a controversial study area as empirical studies have been very much conclusive (Tucker, 2011).

The fact that deficits in the governments today may reduce amount of capital stock which would still be accessible to coming generations does not mean that such government deficits are wrong. If, say the deficits were utilized in the public sector investment, subsequently the private capital reduction set aside to the future is counterbalanced an increase in provision of capital in the public sector. Coming generations will have more schools in as much as the buildings will be fewer.

References

Arnold, R. A. (2008). Macroeconomics. Mason, OH: Thomson/South-Western.

Dwivedi, D. N. (2010). Macroeconomics: Theory and policy. New Delhi: Tata McGraw Hill Education Pte Ltd.

Tucker, I. B. (2011). Macroeconomics for today. Mason, OH: South-Western Cengage Learning.