SUNY Constraining Government Expenditure on Domestic Goods & Services Paper

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SUNY at Buffalo

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1. During the passage of the U.S. fiscal stimulus bill of February 2009, many members of Congress demanded “buy American” clauses, which would have prevented the government from spending money on imported goods. According to DD-AA model, would U.S. government spending constrained by “buy American” restrictions have had a bigger effect on U.S. output than unconstrained U.S. government spending? Why or why not? 2. Apply the DD-AA model to analyze the effect of 2018 U.S. trade war on U.S. economy. Consider both a temporary and permanent import tariff, respectively. 3. Suppose U.S. Congress passes a constitutional amendment requiring the government to maintain a balanced budget at all times. Thus, if the government wishes to change government spending, it must always change taxes by the same amount, that is, ∆G = ∆T. Does the constitutional amendment imply that the government can no longer use fiscal policy to affect employment and output? (Hint: Analyze a “balanced-budget” increase in government spending, one that is accompanied by an equal tax hike.) 4. A simple mathematical version of the DD-AA model can be constructed as follows: Consumption function: C=(1-s)Y, where s is the savings rate, or marginal propensity to save. Current account function: CA=aE-mY, where m is marginal propensity to import. Output market equilibrium: Y=C+I+G+NX=(1-s)Y+I+G+aE-mY Money market equilibrium: M/P=bY-dR, where b and d are liquidity preference coefficients. Suppose that the central bank can hold both the interest rate R and the exchange rate constant, private investment I is also constant, what is the effect of an increase in government spending G on equilibrium output Y? 5. All else equal, a country’s currency depreciates while its current account worsens. What data might you look at to decide whether you are witnessing a J-curve effect? What other macroeconomic change might bring about a currency depreciation coupled with a deterioration of the current account, even if there is no J-curve effect?
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Explanation & Answer

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1

1. Constraining government expenditure on domestic goods and services would not have a
more significant effect on the country's Gross National Product. That is because
constraining government spending on local goods and services would lower investment
in the following ways. First, taxes would increase. Secondly, the prices of primary
products and services would increase. The overall government expenditure would decline
as well as transfer payments.
2. The elevation of tariffs by the government has numerous implications for prices and
investment, which, in turn, reduce the Gross National Product. For instance, by raising
tariffs (therefore taxes), prices for the general goods and services increase as producers
attempt to transfer the higher cost of production to consumers. Due to the dead-weight
loss incurred by the economy, government and private spending generally decline, which
in turn reduces the overall investment. The decline in investment shifts the DD curve to
the left, which ultimately lowers the Gross National Product.
3. Amending a balanced budget does not mean that levels of employment, as well as output,
will be the same after an expansionary or deflationary change. The increment in
government spending, which equals the increase in taxes, triggers a proportionate
increment in output, as well as employment. Therefore, the government may still induce
changes in production with a balanced budget.
4. Government spending will increase investment, and the DD curve will expand outwards.
At the same time, the AA curve will not move because the foreign exchange rate and the
interest rate remain constant. As a result, bo...