Macroeconomics Solution – Case: The government and the National Highway

Project. Please note that my answers are long as I have given additional notes for
your understanding. Most simplified and “to the point” answers are sufficient.

Q1.
This answer is relatively simple. Increase in G will lead to an increase in income
flows in the country. This will lead to more job creation, increasing employment and
therefore inceased aggregate demand. This increase in AD will stimulate output
growth and give a stimulus to manufacturing etc and across all sectors. There is a
multiplier effect that takes place.

The multiplier effect refers to the idea that an initial spending rise can lead to an
even greater increase in national income. In other words, an initial change in
aggregate demand can cause a further change in aggregate output for the economy.

The multiplier effect is a tool used by governments to restimulate aggregate demand.

This can be done in a period of recession or economic uncertainty. The money
invested by a government creates more jobs, which in turn will mean more spending
and so on.

Q3. The types of deficits mentioned in the case are budgetary deficit, fiscal deficit
and revenue deficit.

A budget deficit occurs when an entity (often a government) plans to spend more
money than it takes in. The opposite of a budget deficit is a budget surplus. Debt is
essentially an accumulated flow of deficits. In other words, a deficit is a flow and debt
is a stock. An accumulated deficit over several years (or centuries) is referred to as
the government debt. Government debt is usually financed by borrowing, although if
a government's debt is denominated in its own currency it can print new currency to
pay debts. Monetizing debts, however, can cause rapid inflation if done on a large
scale. Governments can also sell assets to pay off debt. Most governments finance
their debts by issuing long-term government bonds or shorter term notes and bills.

Fiscal Deficit - When a government's total expenditures exceed the revenue that it
generates (excluding money from borrowings). Deficit differs from debt, which is an
accumulation of yearly deficits.

So the difference between budgetary and fiscal deficit is only that the
budgetary deficit is the deficit over the planned expenditure and the fiscal talks about
actuals. Usually both terms are used interchangeably.

Revenue Deficit - When the net amount received (revenues less expenditures) falls
short of the projected net amount to be received. This occurs when the actual
amount of revenue received and/or the actual amount of expenditures do not
correspond with predicted revenue and expenditure figures. This is the opposite of a
revenue surplus, which occurs when the actual amount exceeds the projected
amount.

[For example, consider an organization or government with budgeted revenue of

$325,000 and budgeted expenditures of $200,000, which equates to a net amount of
$125,000. During the fiscal year, the organization's total revenue is actually
$300,000, while its total expenditure is $195,000. The net amount received by the
organization is $105,000, which is $20,000 less than the projected receipt of
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$125,000. Therefore, although the organization generated a positive net amount of
proceeds, it fell short of the projected amount, creating a revenue deficit.]

Q4.Deficit spending - When the expenditures of a government (its purchases of

goods and services, plus its transfers (grants) to individuals and corporations) are
greater than its tax revenues, it creates a deficit (fiscal) in the government budget;
such a deficit is known as deficit spending. This therefore causes the government to
borrow capital from the 'world market', increasing further debt, debt service (interest),
and interest rates. This borrowing is known as deficit financing.

This is a soft option because according to the case the economy is already under
pressure. There is rising inflation caused mainly due to increase in international fuel
prices. This has also resulted in domestic commercial borrowing is reducing and this
has created a crowding out effect on the corporate sector. Interest rates are also
high, with rising prices, no revenues due to low sales; the interest repayment burden
on the government has increased. The Government will not be able to handle such a
high interest repayment on any of the deficit financing options.

Q5.Refer to class slides/Text book

Q6. Direct answer from the case. Also the latter half of the answer to the Q1.

ADDITIONAL NOTE:
Fiscal policy involves the Government changing the levels of Taxation and Govt
Spending in order to influence Aggregate Demand (AD) and therefore the level of
economic activity.

AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

The purpose of Fiscal Policy:

• Reduce the rate of inflation, (UK government has a target of 2%)
• Stimulate economic growth in a period of a recession.
• Basically, fiscal policy aims to stabilise economic growth, avoiding the boom and
bust economic cycle.

Fiscal Stance:
• This refers to whether the govt is increasing AD or decreasing AD

Expansionary (or loose) Fiscal Policy.

• This involves increasing AD,
• Therefore the govt will increase spending (G) and cut taxes. Lower taxes will
increase consumers spending because they have more disposable income(C)
• This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

• This involves decreasing AD
• Therefore the govt will cut govt spending (G)
• And / or increase taxes. Higher taxes will reduce consumer spending (C). This
will lead to an improvement in the government budget deficit

Fine Tuning: This involves maintaining a steady rate of economic growth through
using fiscal policy. However this has proved quite difficult to achieve precisely.
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Automatic Fiscal Stabilisers (or automatic stabilizers)
• If the economy is growing, people will automatically pay more taxes (VAT and
Income tax) and the Government will spend less on unemployment benefits. The
increased T and lower G will act as a check on AD.
• In a recession the opposite will occur with tax revenue falling but increased
government spending on benefits, this will help increase AD

Discretionary Fiscal Stabilisers

• This is a deliberate attempt by the govt to affect AD and stabilise the economy,
e.g. in a boom the govt will increase taxes to reduce inflation
• Injections (J): This is an increase of expenditure into the circular flow, it includes
govt spending (G), Exports (X) and Investment (I)
• Withdrawals (W): This is a leakage from the circular flow. This is household
income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes
(T) + Net Imports (M)