posted by Bridgett on .
Assume that the economy is already in a recession, and both the President and Congress have decided to do something to restore the economy. Both agree that lowering taxes would not be a good idea, but do believe that it is in the best interest of the economy to increase government spending in defense, education & infrastructure.
The President and Congress change the budget accordingly, but after 18 months, GDP only increased by three quarters of the expected amount. What factors might be responsible for this situation?
If the GDP increased by 3/4 of the expected amount in 18 months, something is working right. Given this little information, I'd recommend continuing what they were doing.
Reasons abound. I will give you 3 to get you started.
Obvious reason #1) If government spends more without taxing more, it must borrow the funds. An increase in demand for loanable funds raises interest rates, which in turn, lowers private investment. This is referred to as "crowding out"
Reason #2) There was certainly an expected multiplier effect associated with the extra spending. However, in a recession, people reduce their spending on consumer goods (i.e., the marginal propensity to consume goes down.) So, the multiplier effect may not have been as large as expected.
Reason #3) Besides government spending, GDP is comprised of Consumption (C), investments (I), and net exports (M-X). Any forecast error in any of these components would lead to a lower GDP than expected.