Explain two reasons why a government might

want to subsidize a good or service.

Answer- subsidy refers to assistance by the government to individuals or firms, consumers or sectors
of an economy. Subsidy may take the form of cash payment or low interest loans. The diagram
below shows the effect of subsidy

A government may grant subsidy to increase revenues (and hence incomes) of producers. Subsidies
have the effect of increasing the revenues of producers. Therefore, governments often grant
subsidies to particular producers whose revenues (and therefore incomes) they would like to
support. This is most commonly done for producers of agricultural products.

subsidies can correct allocative inefficiency by correcting a market failure.

If the government provides a subsidy to a

firm per unit of the good produced that is equal to the external benefit, then the marginal private
cost
(MPC = supply) curve shifts downward (or rightward 4) until it coincides with the MSC curve, as
shown in Figure 5.11(b). The result is to increase quantity produced to Qopt and to lower the price
from Pm to Popt. The problem of underallocation of resources and underprovision of the good is
corrected, and allocative efficiency is achieved. For example Health care – free universal health care
can ensure everyone gets vaccinated; this prevents the spread of infectious disease, which benefits
everyone. In other words, you have a personal benefit from other people being healthy.
Discuss the view that governments should tax the
consumption of gasoline
Indirect taxes are imposed on spending to buy goods and services. They are paid partly by consumers, but are
paid to the government by producers (firms), and for this reason are called ‘indirect’. There are two types of
indirect taxes:

excise taxes, imposed on particular goods and services, such as petrol (gasoline), cigarettes and alcohol

taxes on spending on all(ormost)goodsand services, such as general sales taxes (used in the United States)
and value added taxes

negative externality of consumption refer to external costs created by consumers

When there is a consumption externality, the marginal private benefit (demand) curve does not reflect social
benefits.

The benefits to society are less than the benefits to the consumer, because there is negative utility
suffered by the third parties. The good or service is over- consumed and so there is a welfare loss. For
all units of output greater than Qopt, MSC > MSB, indicating that too much of the good is produced. The welfare
loss is equal to the difference between the MSC and MSB curves for the amount of output that is overproduced
relative to the social optimum (Qm – Qopt). It represents the loss of social benefits from overproduction due to
the externality.

To correct this the government can impose indirect tax on gasoline and to make another source of government
revenue. The revenue will be high because gasoline has low PED.

For example delhi the people pay around 53 rupees tax per litre.
This will affect different stakeholders also

Consumers -Consumers are affected in two ways: by the increase in the price of the good (from P* to Pc,
shown in Figure 4.2) and by the decrease in the quantity they buy (from Q* to Qt). Both these changes make
them worse off, as they are now receiving less of the good and paying more for it.

Producers (firms) -Producers are affected in two ways: by the fall in the price they receive (from P* to Pp),
and by the fall in the quantity of output they sell (from Q* to Qt). These effects translate into a fall in their
revenues, from P* × Q* before the tax to Pp × Qt. Firms are therefore worse off as a result of the tax. It will
also effect car producing firms because the consumers will be less likely to buy a car as the fuel price becomes
expensive.

The government -The government is the only stakeholder that gains, as it now has revenue equal to (Pc − Pp)
× Qt in Figure 4.2. This is positive for the government budget.

Society as a whole -Society is worse off as a result of the tax, because there is an under allocation of resources
to the production of the good (Qt < Q*).

Explain how expansionary fiscal policy could be

used to close a deflationary (recessionary) gap.
The set of government policies regarding taxation and government spending. Fiscal policy is used to manage aggregate
demand (AD) in the economy.

Expansionary fiscal policy: Government policy to raise AD in the economy by lowering taxes and increasing
government spending.

Deflationary gap When real GDP is less than potential GDP, the economy is experiencing a recessionary gap
and unemployment is greater than the natural rate of employment.

SRAS intersects AD (opposite) AD1 to AD2 where the economy will achieve full
employment or potential output, Yp, thereby closing the recessionary gap. Fiscal policy undertaken to
eliminate a recessionary gap is called expansionary fiscal policy, because it works to expand
aggregate demand and the level of economic activity. Expansionary fiscal policy may consist of:

increasing government spending

 decreasing personal income taxes

  decreasing business taxes, or
 a combination of increasing spending and decreasing taxes.

An increase in government spending impacts directly on aggregate demand, which increases. If the government
decreases taxes, aggregate demand is affected in a two-step process. If personal income taxes are cut, the result
is a rise in disposable income, which is then likely to lead to an increase in consumption spending, causing the
AD curve to shift to the right .If business taxes are cut, after-tax business profits increase, which in turn is likely
to lead to higher investment spending and therefore higher AD. In all three cases, AD is intended to shift to the
right from AD1 to AD2, allowing the economy to achieve full employment or potential output Yp.

For example-Japan

Evaluate the view that fiscal policy is the most

effective way of achieving long-term economic
growth.
long-run growth is the increase in the market value of goods and services produced
by an economy over a period of time. The long-run growth is determined by
percentage of change in the real gdp.

Indirect effects on potential output

Consumers and firms need a stable economic environment to be able to plan and carry out their economic
activities. Firms, in particular, must make plans in many areas, including what capital goods to invest in, and
whether, how and in what areas to pursue research and development (R&D) and technological innovations.
Investment is the key to the formation of new capital goods, and R&D is the driving force of technological
changes, both of which are very important factors in increasing production possibilities and increasing potential
GDP (shifting the LRAS curve to the right in the monetarist/new classical context). To be in a position to plan
over long periods of time, firms need economic stability, consisting of avoidance of sharp economic upturns
(inflation) and downturns (recession and unemployment). Fiscal policy aiming at economic stabilisation is
therefore important in creating the macroeconomic environment that encourages activities impacting on long-
term economic growth.

Direct impact of government spending on aggregate demand. Changes in government spending impact
directly on aggregate demand, and this can be helpful to policy-makers who want to be reasonably certain that
changes in spending are likely to change aggregate demand in the desired direction. Changes in taxes are less
direct, as they work by changing consumer disposable income and firm after-tax profits, and this poses some
uncertainties about their effects on aggregate demand.

It also had disadvantages crowding out

Crowding out. If the government pursues an expansionary fiscal policy involving spending increases without
an increase in revenues, it is forced to borrow; this is called deficit spending. Government borrowing involves
an increase in the demand for money, and leads to an increase in the rate of interest. A higher interest rate in
turn can lead to lower investment spending by private firms, or a ‘crowding out’ of private investment. This
means that the government’s expansionary fiscal policy is weakened, since a greater G (government spending)
is counteracted by a lower I (investment spending). Crowding out is illustrated in Figure where the fall in I is
equal to the increase in G. Crowding out is controversial. in a recession, the stimulus provided to the economy
by the government’s increased spending may raise output and employment, improve business expectations
about their future sales, and increase investment spending in spite of the increase in the interest rate. In this case,
the government’s deficit spending is less likely to crowd out private investment. Other economists, mainly in the
monetarist/new classical tradition, believe that investment spending will be crowded out in the event of deficit
financing even in a recession.