1. An article in the Wall Street Journal criticized the concept that an increase in government spending can generate an increase in GDP equal to a multiple of the amount spent:
“In what passes for debate in Washington, the prevailing notion seems to be ‘putting money in people’s pockets.’ This might be called single-entry Keynesianism, since the money the government puts in pockets arrives by immaculate conception. Something like this was indeed taught in Econ 101 in the 1950s; the government ‘injected’ money, remember, to be ‘multiplied’ a number of times depending on ‘the marginal propensity to consume.’ Consumption good, savings bad.
“By the 1960s, the monetarist school of economics had revived, and asked, where does the government get this money it ‘injects.’ If it’s created by the Fed, you’re talking about monetary policy, not fiscal policy. If it isn’t, you have to siphon whatever you ‘inject’ out of the private sector by taxing or borrowing. How does it stimulate to take with one hand and give with the other?” (Bartley, Robert L. “Thinking Things Over: Does Spending Stimulate? Do Deficits?” Wall Street Journal, February 4, 2002 (Eastern edition): pg. A.17)
The criticism above implies that fiscal policy alone cannot change aggregate demand because any increase in government purchases must be financed either by raising taxes or borrowing.
a. Suppose taxes paid by households are raised by $100 million in order to finance an additional $100 million of government expenditure. Explain why there would be a net increase in aggregate demand as a result.
b. Suppose that to finance $100 million of additional government expenditure, the government runs a $100 million budget deficit instead of increasing taxes. How will this policy affect aggregate expenditure and aggregate demand?