Question

** LUIE detination Fiscal policy Budget deficit Budget surplus National Debt Marginal Tax Rate Progressive tax Regressive tax Deficit Dove Deficit Hawk Automatic Stabilizers Laffer curve 1. Use the loanable funds model to explain why classicals argue that government deficits crowd out private spending. Explain why Keynesians argue that government deficits crowd in private spending. 2. Explain the logic behind "trickle down economics" (i.e the supply-side argument in favor of cutting taxes on the wealthy). Explain why Keynesians don't believe it will work. 3. Explain the difference between a government deficit and the national debt. 4. What are automatic stabilizers? Give examples. How are they distinguishable from discretionary fiscal policy?

Answer 1

1. According to loanable funds model, when the government runs a budget deficit, that is, the government borrows money it increases the market demand for loanable funds. Graphically, since the supply of loanable funds remains the same, a shift in demand for loanable funds consequently results in the increase in the market interest rates. This increase in the interest rates acts as a disincentive for private investors as it makes private investment more expensive than before. This is how the classicals justfied that government deficits crowd out private spending.

On the contrary, Keynesians argue that government deficits crowd in private investment if the economy is operating below full capacity. They rule out crowding out effect especially in recession and liquidity trap since the government is ideally spending the otherwise unused resources. The rise in government spending can effectively absorb the under-utilised capacity and may even set off a multiplier effect.

2. Trickle down economics refers to the proposition that cutting taxes on the wealthy can drive the economy to growth, increasing incomes at all levels. It is based on the supply side rationale that supply creates its own demand. Since taxes act as a deterrent to increasing supply, a reduction in taxes would increase production, which in turn would increase both- the level of employment and the rewards earned by workers, consequently driving the economy to a higher growth path.

Keynesians reject this theory as they do not approve of Say's Law of Market. The basic distinction between the Classicals and the Keynisans is that the former rely on supple side mechanism while the latter give importance to the demand side mechanism. Keynesians advocate that the lower income sections can be made better off only through government intervention which may take the forms of progressive taxation, that is lower taxes on the poor (who actually consume) and higher taxes on the wealthy ( who actually produce). This is so because the money which is not collected in taxes in trickle down economics returns to the wealthy class instead of the poor workers, thus, defeating the rationale of the trickle down economics.

3. A government budget deficit refers to the situation when the government's expenditure exceed its revenue over a specific period, generally a year. On the other hand, the national debt is the consecutive accumulation of each year's deficit (that is, total debt).

4. Automatic stabilizers are a fiscal policy tool used to combat fluctuations or negative economic shocks in a nation's economic market that require no regular intervention or assessment by the government. They affect the normal operations in an economy organically without additional time to time interference by the government. Examples include progressive taxation and welfare transfer payments which are self correcting in nature.

Automatic stabilizers are distinguishable from discretionary fiscal policy as the latter are a tool to stabilize the economy during special circumstances. In discretionary fiscal policy, the government undertakes legislative action by altering laws such as changing tax structure to address a specific problem (such as recession or inflation).