Question

Analyze in detail through the income-expenditure model of sticky prices, the impact that increased public spending and taxes may have on GDP, given government spending and taxes increase by the same amount.  

Answer 1

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                                    Sticky prices refer to those prices that do not adjust immediately to the changing economic conditions. The theory of sticky prices is used to explain why the aggregate supply curve is upward sloping in the short run. The stickiness means that the change in the money supply have an impact on the real economy which causes changes in the investment, employment, output, consumption etc. The following are the various effects of sticky prices based in an income expenditure model

· If the process are sticky, then higher planned expenditure like government spending would boost the production and hence boosts the income.

· As income increases, the consumption also increases and hence would again lead to boosting of planned expenditure.

· Price stickiness in this model is somewhat in disagreement to the law of supply an demand and states that the prices are at a constant level or varies only slowly with respect to change in the supply and demand.

· As the prices cannot change with respect to the market economics, it would lead to the inefficiency of the market and hence would result in market not reaching the stable equilibrium state.

· As the taxes are increased, the disposable income would decrease leading to a less consumption in a real market. But with sticky prices, the variation of this price change would be slow. Thus, although there are effects on the consumption pattern, there would not be a considerable decrease as the price levels are not varying in a rapid manner. Thus, the GDP would decrease only in a slow manner in such increased tax situations.

· As the government spending is also expected to increase, this would result in more induction of money in the economy and hence the demand for prices would decrease and the prices would start falling. Thus the increased public expenditure would be countered by government spending in the market along with increase in taxation.