2011 Essay Question 4

Question

(a) Explain the process whereby an increase in government expenditure can lead to a bigger change in national income. [10]

(b) Discuss the extent to which conflicts in government macroeconomic objectives limit the scope for the use of fiscal policy in any economy. [15]

Answer

(a) Students should distinguish between government expenditure on goods and services and government expenditure on transfer payments.

An increase in government expenditure on goods and services will lead to an increase in aggregate demand. For example, the Chinese government increased expenditure on goods and services by US$586b in the 2008-2009 Global Financial Crisis.

An increase in government expenditure on transfer payments will lead to an increase in disposable income. When this happens, consumption expenditure will rise which will lead to an increase in aggregate demand. For example, the US government increased expenditure on transfer payments by US$168b in the 2008-2009 Global Financial Crisis.

An increase in aggregate demand will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. Furthermore, the initial increase in aggregate demand due to the increase in consumption expenditure and government expenditure on goods and services will lead to increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income and this is commonly known as the multiplier effect. As the question only requires students to discuss the effect on national income, they need to explain the full multiplier.

Suppose that the marginal propensity to consume domestic goods and services (MPCD) is 0.8, the marginal propensity to withdraw (MPW) is 0.2 and the increase in autonomous expenditure (ΔAE) is $1000. When autonomous expenditure rises by $1000, firms will employ more factor inputs from households to increase production and hence will pay households more factor income. When households’ income rises by $1000, they will increase consumption expenditure on domestic goods and services by $800 (0.8 × $1000). Due to the increase in consumption expenditure on domestic goods and services, firms will employ even more factor inputs from households to further increase production and hence will pay households even more factor income. When this happens, households’ income will rise further by $800 which will induce them to further increase consumption expenditure on domestic goods and services by $640 (0.8 × $800). However, each time households’ income rises, they will pay more taxes, increase savings and buy more imports. In other words, withdrawals will increase when households’ income rises. When withdrawals rise by $1000, which is equal to the increase in autonomous expenditure, injections will once again be equal to withdrawals. When this happens, equilibrium will be restored and national income will stop rising.

Round

ΔY

ΔCD

ΔW

1

$1000

$800

$200

2

$800

$640

$160

3

$640

Sum

$5000

$4000

$1000

In the above table, the increase in national income of $5000 is greater than the increase in autonomous expenditure of $1000. The multiplier is the number of times by which national income rises due to an increase in autonomous expenditure. It is the inverse of the marginal propensity to withdraw which is the sum of the marginal propensity to save, the marginal propensity to tax and the marginal propensity to import. The marginal propensities to save, tax and import are the proportions of an increase in national income that are saved, taxed and spent on imports. Therefore, the multiplier will be larger the lower the savings, the lower the income taxes and the lower the imports.

Students should also discuss the potential effect of an increase in government expenditure on aggregate supply and hence national income. For example, government expenditure on education and training will lead to a fall in the cost of production and an increase in the production capacity in the economy.

Conclusion

The conclusion can simply be a summary or recommendation as there are no evaluation marks.

Answer

(b) Assume that the government uses expansionary fiscal policy to reduce unemployment.

To decrease unemployment, the government can increase expenditure on goods and services. For example, the Singapore government implemented the Resilience Package which included an increase in expenditure on infrastructure to increase economic growth in the 2008-2009 Global Financial Crisis. It can also increase disposable income to increase consumption expenditure by decreasing direct taxes such as personal income tax and corporate income tax or increasing transfer payments. In addition to an increase in consumption expenditure, a decrease in corporate income tax will lead to higher expected after-tax returns on planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

The use of expansionary fiscal policy to decrease unemployment may conflict with the macroeconomic goal of low inflation. An increase in aggregate demand will lead to a shortage of goods and services resulting in a rise in the general price level. Furthermore, when aggregate demand rises which will induce firms to increase production, the increase in the demand for factor inputs in the economy will lead to a rise in the prices. When this happens, the cost of production in the economy will rise which will induce firms to increase prices to maintain profitability resulting in a rise in the general price level. If there are moderate to high inflationary pressures in the economy, a rise in inflation is likely to lead to high inflation.

The use of expansionary fiscal policy to decrease unemployment may conflict with the macroeconomic goal of a balance of payments equilibrium. When national income rises, imports will increase which will worsen the current account and hence the balance of payments. Furthermore, if a rise in inflation makes domestic goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments. If the economy has a balance of payments equilibrium, a deterioration in the balance of payments will lead to a balance of payments deficit. Under the fixed exchange rate system, the balance of payments deficit will be persistent, other things being equal.

The use of expansionary fiscal policy to decrease unemployment may not conflict with the macroeconomic goal of low inflation. If there are no or low inflationary pressures in the economy, a rise in inflation may not lead to high inflation. Indeed, if there are deflationary pressures in the economy, a rise in inflation is likely to lead to low inflation which is desirable for the economy. Furthermore, the use of expansionary fiscal policy to achieve low unemployment may lead to an increase in aggregate supply in the long run. For example, an increase in government expenditure on education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. An increase in the skills and knowledge of labour in the economy will lead to an increase in the production capacity in the economy resulting in an increase in aggregate supply. In addition, it will lead to an increase in labour productivity and hence a fall in the cost of production in the economy resulting in an increase in aggregate supply. If this happens, assuming aggregate demand is rising which is the normal state of the economy, the general price level will rise at a slower rate resulting in lower inflation.

The use of expansionary fiscal policy to decrease unemployment may not conflict with the macroeconomic goal of a balance of payments equilibrium. When national income rises, imports will increase which will worsen the current account and hence the balance of payments. However, if the economy has a persistent balance of payments surplus, a deterioration may help correct the surplus and hence achieve an equilibrium. Furthermore, if inflation falls, domestic goods and services may become relatively cheaper than foreign goods and services. If this happens, net exports will rise which will lead to an improvement in the current account and hence the balance of payments. If the economy has a persistent balance of payments deficit, an improvement may help correct the deficit and hence achieve an equilibrium.

The use of expansionary fiscal policy to decrease unemployment may help achieve the macroeconomic goal of high economic growth as expansionary fiscal policy decreases unemployment through increasing aggregate demand and hence national output.

As the command words are ‘Discuss the extent ‘, students should discuss other factors which may limit scope for the use of fiscal policy to a larger extent. This will naturally be the standard limitations of expansionary fiscal policy such as the inflexibility of government expenditure and taxation, the crowding-out effect, a small multiplier and a high public-debt-to-GDP ratio. Students need to explain only two of the standard limitations.

Evaluation

Point 1: Explain, with examples, why the factor which limits the scope for the use of fiscal policy to the largest extent varies from economy to economy.

Point 2: Explain the Tinbergen Principle to avoid conflicts between macroeconomic goals.

A more elaborate answer to 2011 Essay Question 4 will be provided in the economics tuition class.

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