Q1.

In the four-sector model we recognise the existence of domestic
consumption by households (Cd), planned investment by firms (IP), government
spending (G) and exports (X). The equation for Planned Aggregate Expenditure
(PAE):

PAE=C d + I P +G+X can be expanded since:

C =C´ +c (Y −T ) where Y is output∧T is tax . Also , T =T´ + tY , T´ is tax unrelated to
d

income while tY is tax proportional to income.

´
PAE=C−c T´ + I P +G+ X + c ( 1−t ) Y .
Thus,
Therefore, a reduction in the exogenous components of investment and
consumption due to pessimistic ‘animal spirits’ will lead to a decrease in the
vertical intercept of PAE meaning a decrease in output at every level of income.
This can be seen in the figure below.

´
C∧I P
Since are components of the vertical intercept of PAE, a decrease in
these values will shift PAE0 to PAE1, a vertically downwards shift. This shifts
aggregate output from Ye to Y1, a decrease in output. At Y1, PAE0>Y1. Here,
planned injections=IP+G+X >withdrawals=S(savings)+T(tax)+M(imports).

We expect the economy to grow (firms boost production) in order to reach Y e
from disequilibrium. This is triggered by an unexpected depletion of firms’
inventories since actual output (production) at Y 1 is less than planned. We expect
to see cyclical unemployment increase in this case due to the output gap Y e-Y1.

y e− y 1
According to Okun’s law, 100∗ ( y1 ) =−β (u−u ⋆) and since Ye-Y1 is >0,

cyclical unemployment will increase.

Page 1 of 4

Barro believes that Keynesian theories are incorrect since Keynesian theory suggests that for every dollar put into the economy. And while this may increase output above what it would be without government intervention. Barro does not believe that that government expenditure can have a “magic[al]” (Barro. we cannot determine whether another policy would have been better off for the economy in the long or short term. greater than 1:1 impact on GDP. it may still be lower than normal levels of output which is the difference between the peak of the black output curve and the trough of the red dotted output curve. Finally. it will generate more than a dollar in increased economic activity. it would be expected that a plot that measures the change in output and government spending to have a positive correlation if Keynes’ theory was correct or a negative correlation if the supply side view of fiscal policy was more accurate. government spending should increase during recession. 2009). Barrow attempts to estimate this multiplier by obtaining figures from times of war. Page 2 of 4 . This is represented by the dotted red line on the stylised model below. Barrow divided the increase in GDP for the period 1943-44 by the defence expenditure and obtained 0. Additionally. it is also very difficult to conduct macroeconomic experiments given the sheer size of the macro economy. the counterfactual cannot. The issue is that according to Keynesian theory. the more that is generated by the multiplier for output. there are difficulties with measuring the effect of fiscal policy on output. for a multiplier greater than 1.8 as the multiplier but contested that even this value was overstated for a number of reasons. Thus. there would not likely be vast discrepancies in opinion between highly respected economists (Luis Cabral and Paul Krugman for example). Q3. specifically WW2 which saw a major increase in government spending predominantly towards the war effort. Firstly. He contests that if the multiplier really is greater than 1. Even if the effect of fiscal policy could be measured.Q2. then why would the government stop spending at $1 trillion of added purchases since the more you spend. If empirical evidence was clear. Therefore data would prove to suggest in this case that output has decreased when government spending has increased which is the opposite of what Keynesian theory intended.

even if the whole dollar does not go towards output. Instead. Government spending puts unemployed workers and capital to work that would otherwise be unutilised by the private sector. Barro suggests decreasing government transfers that are often a disincentive for individuals to find work (reliant on welfare). output will grow by the multiplier value. if the Keynesian model is taken to be true then during a recession. Barrow contests. If the multiplier is between 0 and 1 then the government spending has Page 3 of 4 . 2011)). in times of recession. Thus. Whether the government spending multiplier lies between 0 and 1 does not necessarily mean that governments should refrain from fiscal spending during recessions. a small increase in GDP is beneficial. It means that for every dollar of fiscal spending. 2009). Barro also recommends abolishing federal corporate income tax due to its tendency to double-tax (first corporations and then when stakeholders receive dividends or capital gains (Barrow. when individuals tend to save their income instead of investing it. it will still increase output. that all fiscal spending should justify the social cost incurred. Q5.Q4. Barrow believes that the focus on spending should be that it passes a social cost- benefit analysis as “it is wrong to think that added government spending is free” (Barro. Additionally. 2009). the marginal income-tax rate should be reduced. the tax required can act as a disincentive for individuals and businesses to work and invest if their work is going to be taxed at a higher rate. Thus. This is in regards to the Keynesian model which believes that increased government expenditure will increase output. Barro suggests incentivising people and businesses to “invest. On the contrary. Since government spending needs to be financed through either tax or borrowing where borrowing will inevitably need to be repaid using tax. However. produce and work” (Barro.

(2009). J. 17. Government spending is no free lunch. References Barro. J. So whether the multiplier is above or below one. How to really save the economy. (2011.in effect crowded out the government spending that would have otherwise taken place. September 10). The Wall Street Journal. R. Barrow. Page 4 of 4 . this can have a positive effect on GDP in the short-run but can also incur a longer-term debt problem. fiscal spending can be beneficial for the economy during recessions depending on the economic model used and whether the spending will justify the social cost involved. R. The New York Times. A. Even when the multiplier is greater than 1.