During the recent recession, when countries around the world suffered high unemployment rates and the governments were experiencing huge budget deficits, economists debated whether to raise or cut taxes or to raise or cut government spending. Many argued that the governments could raise taxes on certain income groups and, at the same time, increase spending to give a boost to the economy.
a) Let us consider a hypothetical example to examine the merit of this argument. Assume that an economy was in a liquidity trap and its initial GDP was 10,000 billion dollars and the marginal propensity to save was 10%. Assume away the foreign trade sector. How much would be the change in income (GDP) if the government increased both spending and taxes by 20 billion dollars?
b) Do you expect the same result to hold in the standard model where the IS curve and the LM curve are of normal shapes? Explain.
During the recent recession, when countries around the world suffered high unemployment rates and the governments were experiencing huge budget deficits, economists debated whether to raise or cut taxes or to raise or cut government spending. Many argued that the governments could raise taxes on certain income groups and, at the same time, increase spending to give a boost to the economy.
a) Let us consider a hypothetical example to examine the merit of this argument. Assume that an economy was in a liquidity trap and its initial GDP was 10,000 billion dollars and the marginal propensity to save was 10%. Assume away the foreign trade sector. How much would be the change in income (GDP) if the government increased both spending and taxes by 20 billion dollars?
b) Do you expect the same result to hold in the standard model where the IS curve and the LM curve are of normal shapes? Explain.
