Chapter 27: Problem 1

Why can a $\$ 1$ increase in government purchases lead to more than a $\$ 1$ increase in income and spending?

Short Answer

Expert verified

A $\$1$ increase in government purchases can lead to more than a $\$1$ increase in income and spending due to the multiplier effect. It begins with the government injecting money into the economy, creating demand, and subsequently employment and income. As households earn more, they spend more, creating even more demand, leading to a cycle where the original injection of spending is multiplied.

Step by step solution

Understanding Fiscal Policy

Fiscal policy is the use of government revenue collection (mostly taxes) and expenditure (spending) to influence a country's economy. It includes the management of inflation, unemployment, and economic growth.

The Concept of Government Spending

In fiscal policy, government spending is considered an important aspect. This includes money spent on infrastructure, public services, and others. Such spending is a way of injecting money into the economy.

Introducing the Multiplier Effect

The multiplier effect is a principle that states that a change in income can lead to an even larger change in spending. This happens due to the income received being spent by the recipient, creating income for others, and a cycle continues.

Applying the Multiplier Effect to Government Spending

When the government increases its purchases by $\$1$, it initially increases the total demand in the economy, leading to an increase in production. This increased production requires more labor, leading to more employment, which subsequently leads to an increase in household income. These households then spend more, increasing the demand for goods and services. This, in turn, leads to even more production, requiring more labor, and the cycle continues. This is why a $\$1$ increase in government spending can lead to more than a $\$1$ increase in income and spending.

Conclusion

The reason why a $\$1$ increase in government purchases can lead to more than a $\$1$ increase in income and spending is due to the multiplier effect. Understandably, this process will not go on indefinitely. Other factors such as the withdrawal of spending through saving, taxation, and imports will limit this multiplier effect.