Assume that policy makers pass

Assume that policy makers pass a budget that calls for anincrease in government spending. In an open economy, which of thefollowing will occur as a result of this fiscal policy action?Select one: a. Private saving increases. b. Investment decreases.c. The current account worsens. d. Either A or C occurs. e. EitherA, B, or C occurs.

Answer:

Answer:(d) Either A or C

Either Private savings increases or the current account worsens,here’s why;

When government spending increases, it essentially means thatthe government allocates funds into projects and investment thatbenefit the society as well as improve private and governmentincome. Say the government spends money into constructing a publicsector held bread factory. The funds that are spent in theconstruction of the factory are the income of several people whoare associated with the construction of the same project. Thusthese people’s individual / private income is expected to increase.Also, after the construction of the factory is complete, thegovernment is expected to employ a number of people into it’soperations from production, distribution, marketing etc and theincome of these people rise as well.

Thus, in general when government spendingrises,  private income is also expected to rise alongwith private savings and private investments and so does rise theaggregate demand for goods and services. Thus with the increase ingovernment expenditure, private savings increases as a result.

At times, there is a current account deficit as a result ofexcess government spending. A current account is part of a nation’sBalance of payments, which shows all current nature transactions (one way / unilateral transactions). A current account ends up in adeficit when there are more current transactions PAID than currenttransactions RECEIVED.

A current account may end up in a deficit as a result of bad andunplanned government spending. Governments allocate funds for thepurpose of being spent for various needs of the nation. Many atimes, these needs can be on those avenues where the economicproductivity returns are low and do not contribute much towardsoverall productivity or towards the GDP.

Say government increases it’s spending for acquiring defenseequipments and financing military expenses or it spends a lot ofmoney on unemployment aid and other poverty alleviation schemes,where the returns to productivity is low. Expenditure such as thisdo not contribute much in return towards overall economicproductivity and thus increases the deficit in the government’scurrent account.

Thus the possibilities of increased government spending couldeither be an increase in private savings or the current accountworsens


 
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