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Question

if a government keeps a balanced budget, then what will happen out of the following choices?

a) the economy won't ever slide into a recession

b) economic growth will be spurred by proving to businesses that budgets can be balanced

c) the effect of an increase in government spending on aggregate expenditures is weakened

d) raising taxes has no net effect on spending

Answer 1

b) economic growth will be spurred by proving to businesses that budgets can be balanced

Answer 2

The correct answers is:

c) the effect of an increase in government spending on aggregate expenditures is weakened

[ An increase in govt. spending will increase GDP by manifold if the malrginal propensity to consume is greater than 0. But balance budget will need the increase in govt spending matched by equal amount of rise in taxes. This in turn will reduce GDP many fold. The balanced Budget therefore leads to a multiplier of 1 (one). Thus, balanced budget requirement weakens the effect of govt spending on increasing aggregate expenditure through the negative effect of the equivalent amount of taxation reducing disposable income and hence reducing aggregate consumption expenditure; Govt. spending multiplier is 1/(1-mpc) per dollar of govt. dditional spending whereas the the tax maultiplier is -mpc/(1-mpc) per dollar of addition dollar raised by Tax.

Thus if the budgt is balanced, a dollar of additonal govt spending will be matched by a dollar of additional tax collection. So, the net multplier effect is [ i/(1-mpc) - mpc/(1-mpc)] = (1-mpc)/ (1-mpc) = 1.  If mpc is say 0.9, govt spending multiplier would be 1/(1-0.9)= 1/0.1= 10. Thus a dollar of increase govt spending woulkd have increased aggrgate expenditure by $10, but with balanced budget, the multiplier being 1, aggregate spending will increase by just $1 after an increase in one dollar govt. expenditure balanced by 1 dollar increase in Tax.]