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Chapter 27: Problem 3

Some economists argue that because increases in government spending crowd out private spending, increased government spending will reduce the long-run growth rate of real GDP. a. Is this outcome most likely to occur if the private spending being crowded out is consumption spending, investment spending, or net exports? Briefly explain. b. In terms of its effect on the long-run growth rate of real GDP, would it matter if the additional government spending involves (i) increased spending on highways and bridges or (ii) increased spending on national parks? Briefly explain.

Short Answer

Expert verified
The long-run growth rate of real GDP is most likely to be reduced if the private spending being crowded out is investment spending. The effect of increased government spending on the long-run growth rate of real GDP can be offset if the spending is on infrastructure, contributing to increased productivity. However, increased spending on national parks is less likely to have a significant direct impact on long-run economic growth.

Step by step solution

01

Understanding 'Crowding Out'

The 'crowding out' effect is an economic theory that suggests that increased public spending displaces, or 'crowds out' private sector spending. When the government spends more, it may result in the reduction in spending in the private sector.
02

Analyzing the Impact of 'Crowding Out' on Types of Private Spending

Government spending is most likely to 'crowd out' investment spending rather than consumption spending or net exports. This is because when the government increases spending, it often finances it by borrowing from the financial markets, causing interest rates to rise. This makes borrowing more expensive for businesses, thus reducing their investment in growth.
03

Analyzing the Impact of the Type of Government Spending on Long-Run Growth Rate of GDP

The effect of additional government spending on the long-run growth rate of real GDP depends on the type of spending. If government spending is on areas that directly contribute to increased productivity, like infrastructure (e.g., highways and bridges), it could potentially offset the negative impact of 'crowding out' by enhancing the productivity of the private sector. On the other hand, spending on national parks, although valuable for its social and environmental benefits, is less likely to have a significant direct impact on long-run economic growth.

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