Q1.

In the four-sector model we recognise the existence of domestic

consumption by households (Cd), planned investment by firms (IP), government
spending (G) and exports (X). The equation for Planned Aggregate Expenditure
(PAE):

PAE=C d + I P +G+X can be expanded since:

C =C +c (Y T ) where Y is outputT is tax . Also , T =T + tY , T is tax unrelated to

d

income while tY is tax proportional to income.

PAE=Cc T + I P +G+ X + c ( 1t ) Y .
Thus,
Therefore, a reduction in the exogenous components of investment and
consumption due to pessimistic animal spirits will lead to a decrease in the
vertical intercept of PAE meaning a decrease in output at every level of income.
This can be seen in the figure below.

CI P
Since are components of the vertical intercept of PAE, a decrease in
these values will shift PAE0 to PAE1, a vertically downwards shift. This shifts
aggregate output from Ye to Y1, a decrease in output. At Y1, PAE0>Y1. Here,
planned injections=IP+G+X >withdrawals=S(savings)+T(tax)+M(imports).

We expect the economy to grow (firms boost production) in order to reach Y e

from disequilibrium. This is triggered by an unexpected depletion of firms
inventories since actual output (production) at Y 1 is less than planned. We expect
to see cyclical unemployment increase in this case due to the output gap Y e-Y1.

y e y 1
According to Okuns law, 100 ( y1 ) = (uu ) and since Ye-Y1 is >0,

cyclical unemployment will increase.

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Q2. Barro believes that Keynesian theories are incorrect since Keynesian theory
suggests that for every dollar put into the economy, for a multiplier greater than
1, it will generate more than a dollar in increased economic activity. Barro does
not believe that that government expenditure can have a magic[al] (Barro,
2009), greater than 1:1 impact on GDP. He contests that if the multiplier really is
greater than 1, then why would the government stop spending at $1 trillion of
added purchases since the more you spend, the more that is generated by the
multiplier for output.

Q3. Firstly, there are difficulties with measuring the effect of fiscal policy on
output. If empirical evidence was clear, there would not likely be vast
discrepancies in opinion between highly respected economists (Luis Cabral and
Paul Krugman for example). Additionally, it is also very difficult to conduct
macroeconomic experiments given the sheer size of the macro economy. Even if
the effect of fiscal policy could be measured, the counterfactual cannot. Thus, we
cannot determine whether another policy would have been better off for the
economy in the long or short term.

Finally, it would be expected that a plot that measures the change in output and
government spending to have a positive correlation if Keynes theory was correct
or a negative correlation if the supply side view of fiscal policy was more
accurate. The issue is that according to Keynesian theory, government spending
should increase during recession. This is represented by the dotted red line on
the stylised model below. And while this may increase output above what it
would be without government intervention, it may still be lower than normal
levels of output which is the difference between the peak of the black output
curve and the trough of the red dotted output curve. Therefore data would prove
to suggest in this case that output has decreased when government spending
has increased which is the opposite of what Keynesian theory intended. Barrow
attempts to estimate this multiplier by obtaining figures from times of war,
specifically WW2 which saw a major increase in government spending
predominantly towards the war effort. Barrow divided the increase in GDP for the
period 1943-44 by the defence expenditure and obtained 0.8 as the multiplier
but contested that even this value was overstated for a number of reasons.

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Q4. Since government spending needs to be financed through either tax or
borrowing where borrowing will inevitably need to be repaid using tax, the tax
required can act as a disincentive for individuals and businesses to work and
invest if their work is going to be taxed at a higher rate. On the contrary, Barro
suggests incentivising people and businesses to invest, produce and work
(Barro, 2009).

Additionally, Barro suggests decreasing government transfers that are often a

disincentive for individuals to find work (reliant on welfare). Instead, the marginal
income-tax rate should be reduced. Barro also recommends abolishing federal
corporate income tax due to its tendency to double-tax (first corporations and
then when stakeholders receive dividends or capital gains (Barrow, 2011)).
Barrow believes that the focus on spending should be that it passes a social cost-
benefit analysis as it is wrong to think that added government spending is free
(Barro, 2009).

Q5. Whether the government spending multiplier lies between 0 and 1 does not
necessarily mean that governments should refrain from fiscal spending during
recessions. It means that for every dollar of fiscal spending, output will grow by
the multiplier value. Thus, in times of recession, even if the whole dollar does not
go towards output, it will still increase output. This is in regards to the Keynesian
model which believes that increased government expenditure will increase
output. Thus, if the Keynesian model is taken to be true then during a recession,
when individuals tend to save their income instead of investing it, a small
increase in GDP is beneficial. Government spending puts unemployed workers
and capital to work that would otherwise be unutilised by the private sector.

However, Barrow contests, that all fiscal spending should justify the social cost
incurred. If the multiplier is between 0 and 1 then the government spending has

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in effect crowded out the government spending that would have otherwise taken
place.

Even when the multiplier is greater than 1, this can have a positive effect on GDP
in the short-run but can also incur a longer-term debt problem.

So whether the multiplier is above or below one, fiscal spending can be beneficial
for the economy during recessions depending on the economic model used and
whether the spending will justify the social cost involved.

References
Barro, R. J. (2009). Government spending is no free lunch. The Wall Street
Journal, A. 17.

Barrow, R. J. (2011, September 10). How to really save the economy. The New
York Times.

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