Chapter 11: Problem 6

Why will real GDP tend to rise when government spending and taxes rise by the same amount?

Short Answer

Expert verified

Answer: Real GDP increases when government spending and taxes rise by the same amount because this leads to higher aggregate demand and stimulates economic activity, which in turn increases output. Additionally, the multiplier effect amplifies the impact of increased government spending on real GDP, causing it to rise more significantly than the initial increase in spending alone.

Step by step solution

Understand the Concept of Real GDP

Real GDP (Gross Domestic Product) is a measure of a country's total economic output adjusted for inflation. It represents the total value of all goods and services produced within a country during a specific period of time.

Understand the Role of Government Spending and Taxes

Government spending refers to the funds that are expended by the government on various goods, services, infrastructure, and social welfare programs. Taxes, on the other hand, are the means by which the government acquires funds from the public to finance its expenditures. Both of these factors play a crucial role in influencing real GDP.

Analyze the Impact of Simultaneous Rise in Government Spending and Taxes on Real GDP

When both government spending and taxes rise by the same amount, the initial effect is that the government's budget remains unchanged. However, increased government spending can lead to an increase in aggregate demand, which is the total demand for goods and services within the economy. This increase in demand can boost economic output, leading to higher real GDP.

Discuss the Multiplier Effect

The multiplier effect is an economic concept which states that an increase in government spending can create a more significant increase in real GDP than the initial spending itself. When the government spends on goods and services, it directly injects money into the economy. This money is then circulated by individuals and businesses who receive it, leading to further spending and consumption. These subsequent rounds of spending contribute to the multiplier effect, resulting in a larger overall increase in real GDP.

Conclusion

In conclusion, real GDP tends to rise when government spending and taxes increase by the same amount because it leads to higher aggregate demand and stimulates economic activity, which in turn increases output. Additionally, the mechanism of the multiplier effect amplifies the impact of increased government spending on real GDP, causing it to rise more significantly than the initial increase in spending alone.