Question

3.7 [Related to Solved problem 13.1] Briefly explain whether you agree with the following remark Real GDP is $250 billion below its full-employment level. With a multiplier of 2, if the government increases government purchases by $125 billion or the RBA increases the cash in financial markets by $125 billion, real GDP can be brought back to its full-employment level

Answer 1

Solution:

No, I do not agree with the given remark. It can be explained due to the crowding out effect.

One might think that with multiplier of 2, increasing government expenditure by $125 billion, real GDP will increase by 2*125 = $250 billion, and will cover the discrepancy from full-employment level. But with increase in government expenditure, through goods and money market framework (IS-LM framework), we know this will also increase the interest rates in economy. With increase in interest rate, private savings will also increase, thus private spending will decline. So, effect of increase in government spending is crowded by the effect of decreased private spending, as a result of which full multiplier effect will not take place, and real GDP will still lie under full-employment level. (since real GDP includes both components: government spending and private spending)

Similarly, when the reserve bank increases the cash in financial markets by $125 billion, the interest rate falls, making savings less attractive. So, the private consumption or spending increases. Further, such low interest rates also attracts borrowing and thus, investment spending in economy. These factors lead to increase in aggregate demand, but since, prices are not stable, with such high demand there is inflation in the economy. As a result, though GDP seems to increase, due to higher price level, GDP doesn't reach the optimum of full-employment level in real terms.