An increasein governemtn expenditure in increasing GDP when it is financed by:
a) rasing taxes
b) slling governemtn bonds to the general public
c) selling governemtn bonds to the central bank
d) selling government bonds to the commercial banks
e) both c and d
The right answer is c but I don't know why. Could someone please explain it? Thanks!!
To determine which option would be the correct answer, we need to understand the economic implications of each financing method and how it affects the money supply and GDP.
a) Raising taxes: When the government raises taxes to finance its increased expenditure, it reduces the disposable income of individuals and businesses. This reduction in disposable income can result in lower consumer spending and reduced investment, which could offset the positive impact of increased government expenditure on GDP.
b) Selling government bonds to the general public: This method involves issuing bonds in the open market for individuals and institutions to purchase. When individuals buy these bonds, they are essentially lending money to the government. This leads to an increase in government debt but doesn't directly increase the money supply. The impact on GDP would depend on how the borrowed funds are spent. If the government spends this borrowed money on goods and services, it could increase economic activity and potentially boost GDP.
c) Selling government bonds to the central bank: This method involves the government selling bonds directly to the central bank. The central bank, in turn, pays for the bonds by creating new money. This process is often referred to as "monetizing the debt" because it increases the money supply. When the government spends this newly created money on goods and services, it can lead to an increase in economic activity and GDP.
d) Selling government bonds to commercial banks: If the government sells bonds to commercial banks, it would increase the banks' holdings of government bonds and their assets. Although this doesn't directly increase the money supply, it can indirectly affect it if the banks choose to use these bonds as collateral to borrow funds from the central bank. The borrowed funds could then be used for lending and investment, potentially increasing the money supply and supporting GDP growth.
e) Both c and d: This option combines the direct impact of selling government bonds to the central bank (increasing the money supply) with the potential indirect impact of commercial banks using the bonds as collateral to borrow funds from the central bank (also increasing the money supply). As a result, it can have a more substantial effect on GDP.
Based on this analysis, option c, selling government bonds to the central bank, is likely to have the most direct and immediate impact on GDP since it involves the creation of new money by the central bank. However, option e, combining selling government bonds to the central bank and commercial banks, can have a similar effect on GDP, as it also increases the money supply but through a slightly different process.