Consider the following statements: An additional spending by the Gov

Consider the following statements:

An additional spending by the Government of ₹ X is likely to have less impact on income than an additional transfer of ₹ X to households.
An additional spending by the Government of ₹ X is likely to have less impact on income if it is not accompanied by an expansion in money supply.

Which of the statements given above is/are correct ?

1 only

2 only

Both 1 and 2

Neither 1 nor 2

This question was previously asked in

UPSC CDS-2 – 2024

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Statement 1 is incorrect. In a simple Keynesian model, direct government spending (G) on goods and services has a larger multiplier effect on income than transfer payments (Tr) to households. The government spending multiplier is 1/(1-MPC), while the transfer payment multiplier is MPC/(1-MPC), where MPC is the marginal propensity to consume (between 0 and 1). Since MPC < 1, 1 > MPC, so 1/(1-MPC) > MPC/(1-MPC). This means an additional spending of ₹ X by the government is likely to have a *greater* impact on income than an additional transfer of ₹ X, because households might save a portion of the transfer, whereas government spending is assumed to be fully injected into the economy as demand for goods/services.

Statement 2 is correct. Government spending can be financed in various ways, including taxation, borrowing from the public, or by increasing the money supply (e.g., central bank purchasing government debt). If the government spending is financed by borrowing from the public without an increase in money supply, it can lead to increased demand for loanable funds, potentially raising interest rates. Higher interest rates can ‘crowd out’ private investment, thus reducing the overall positive impact of government spending on income. If the spending is accompanied by an expansion in money supply, it can mitigate or avoid this crowding out effect, potentially leading to a larger overall impact on income. Therefore, spending not accompanied by monetary expansion is likely to have a *less* impact than otherwise.

– Government spending typically has a higher multiplier than transfers.
– Government spending can lead to crowding out if not accommodated by monetary policy.

The actual impact of fiscal policy (spending and transfers) on income is complex and depends on various factors beyond simple multiplier models, including expectations, supply-side responses, and the specific nature of the spending or transfer.

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