Question

Use Keynesian Fiscal Theory only (Keynesian Cross of positive AD and AS) to answer the following questions:

Would you recommend a Balance Budget Multiplier method to bring the economy from a recession to non-inflationary full employment level? Why?

PLS HELP ME, Need to show my professor I can respond to his question confidently! thank you so much in advance

Answer 1

No, I shall not recommend this.

The government spending multiplier is higher than the absolute value of tax multiplier. So, when both government spending (G) and tax (T) are increased by same amount (to balance the budget) to increase aggregate demand during a recession, the increase in GDP caused by the increase in G will be higher than the decrease in GDP caused by the increase in T. The net effect will be an increase in aggregate demand which may shift the AD curve to the further right of LRAS curve, in which case, the new GDP will be higher than the full-employment level and the price level will be higher than the full-employment level, causing inflation.

In following graph, long-run equilibrium is at point A where initial aggregate demand (AD0) intersects initial short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0), with long-run equilibrium price level P0 and real GDP (potential GDP) Y0. During recession, economy is at point B where aggregate demand is lower at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).

When government spending rises and tax rises by an equal amount, aggregate demand rises more than required, and AD1 shifts rightward to AD2, intersecting SRAS0 at point C with higher price level P2 and higher real GDP Y2, thus eliminating recessionary gap but causing an inflationary gap of (Y2 - Y0).

LRASO SRASO и % Ү, у