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.
To understand the possible factors responsible for the situation where the GDP only increased by three quarters of the expected amount despite the increased government spending in defense, education, and infrastructure, there are several factors to consider:
1. Time lag: Economic policies often take time to have an impact on the economy. In this case, 18 months might not have been sufficient for the increased government spending to fully stimulate the economy. Economic effects can be delayed due to various reasons such as bureaucratic inefficiencies, slow implementation of projects, or longer investment turnaround times in sectors like infrastructure.
2. Multiplier effect: The multiplier effect measures the impact of government spending on economic output. If the multiplier effect is lower than expected, it means that the increase in government spending did not generate as much economic activity as anticipated. Factors such as leakages in the economy (e.g., savings, imports) or low marginal propensity to consume (which affects how much people spend out of each additional dollar of income) can reduce the multiplier effect.
3. Crowding out: Another possible factor is crowding out, which refers to the situation when increased government spending leads to higher interest rates, thereby reducing private sector investment. If the increase in government spending led to higher borrowing costs and reduced private investment, it could have limited the overall impact on GDP growth.
4. Fiscal policy composition: While the President and Congress decided to increase government spending in defense, education, and infrastructure, the composition of the spending might play a role. If the allocation of funds within these sectors was not efficient or targeted towards productive investments, it could have limited the overall impact on GDP growth.
5. Macroeconomic conditions: External factors such as global economic conditions, changes in consumer and business confidence, or fluctuations in commodity prices can also influence GDP growth. If these factors were unfavorable during the period of increased government spending, it could have dampened the expected impact on the overall economy.
To better understand the specific factors responsible for the situation, it would be important to analyze economic data, conduct research, and possibly consult with economists and policy experts.