Download Taylor Economics Chapter 33 Test Bank

Chapter 18 Test Bank
Multiple Choice Questions
1. When governments are borrowers in financial capital markets, which of the following is least
likely to be a possible source of the funds from a macroeconomic point of view?
A. central bank prints more money
B. increase in household savings
C. decrease in borrowing by private firms
D. foreign financial investors
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
2. A country's economic data indicates that there has been a substantial reduction in the financial
capital available to private sector firms. Which of the following most likely had the greatest
influence on this economy?
A. especially large and sustained household saving
B. increased borrowing by private firms
C. reduction in influx of funds for foreign financial investors
D. especially large and sustained government borrowing
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
3. If a country's economic data shows private savings of $300 million, government spending of
$350 million, tax revenue of $400 million, and a trade surplus of $75 million, then what does
investment equal?
A. $775 million
B. $475 million
C. $275 million
D. $700 million
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
4. If a country's economic data shows private savings of $500 million, government spending of
$300 million, tax revenue of $400 million, and a trade surplus of $100 million, then what does
investment equal?
A. $600 million
B. $500 million
C. $700 million
D. $900 million
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
5. If a country's economic data shows private savings of $400 million, government spending of
$250 million, tax revenue of $400 million, and a trade surplus of $175 million, then what does
investment equal?
A. $550 million
B. $425 million
C. $800 million
D. $375 million
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
6. If a country's economic data shows that private savings equal $250 million, government
spending equals $400 million, taxes equal $350, and the trade surplus equals $150 million, then
what does investment equal?
A. $50 million
B. $75 million
C. $450 million
D. $350 million
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
7. If a country's economic data shows that private savings equal $300 million, government
spending equals $400 million, taxes equal $300, and the trade surplus equals $100 million, then
what does investment equal?
A. $150 million
B. $175 million
C. $200 million
D. $100 million
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
8. If a country's economic data shows that private savings equal $350 million, government
spending equals $375 million, taxes equal $300, and the trade surplus equals $125 million, then
what does investment equal?
A. $50 million
B. $150 million
C. $425 million
D. $600 million
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
9. In the national savings and investment identity framework, an inflow of savings from abroad is,
by definition, equal to:
A. private sector investment.
B. the trade surplus.
C. the trade deficit.
D. domestic household savings.
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
10. From a macroeconomic point of view, which of the following is a source of demand for
financial capital?
A. savings by households and firms
B. foreign financial investment
C. domestic household private savings
D. government borrowing
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
11. The U.S. economy has two main sources for financial capital; _______________________ and
____________________________.
A. private savings from U.S. households and firms; inflows of foreign financial investment.
B. private sector investment; government borrowing
C. private savings from U.S. households and firms; government borrowing
D. private sector investment; inflows of foreign financial investment from abroad
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
12. If the quantity of financial capital supplied is equal to the quantity of financial capital
demanded then, the national savings and investment identity is written as:
A. (M - X) - S = (G + T) - I
B. S + (M - X) = I + (G - T)
C. S + (G - T) = I - (X - M)
D. S = (X - M) - (G - T)
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
13. When a government records a budget surplus, the national savings and investment identity is
written as:
A. S = I + (G - T) + (X - M)
B. S + (M - X) + (T - G) = I
C. S - (G - T) = I - (X - M)
D. S + (T - G) = 1 + (X - M)
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
14. When a government records a trade surplus, the national savings and investment identity is
written as:
A. S = (G - T) + (X - M) - I
B. S - (G - T) = I - (X - M)
C. S = I + (G - T) + (X - M)
D. S + (G - T) = I - (X - M)
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
15. A __________________ often results in an outflow of financial capital leaving the domestic
economy and being invested in the global economy?
A. trade surplus
B. trade deficit
C. fiscal deficit
D. twin surplus
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
16. A prolonged period of budget deficits may lead to ___________________.
A. outflows of financial capital abroad
B. lower inflation
C. lower economic growth
D. increasing exchange rates
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
17. A ___________________________________ can lead to disruptive economic patterns and heavy
strains on a country’s banking and financial system.
A. prolonged period of trade surpluses
B. sustained pattern of large trade deficits
C. prolonged period of budget surpluses
D. sustained pattern of large budget deficits
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
18. Which of the following is least likely to be the result of economic disruptive patterns caused
by a prolonged period of government budget deficits?
A. high inflation
B. substantial inflows of foreign financial capital
C. increasing exchange rates
D. strains on a country's financial system
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
19. An increase in government borrowing can:
A. allow private investment to expand.
B. crowd out private investment in physical capital.
C. increase the incentive to invest in technology.
D. cause a substantial decrease in interest rates.
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
20. A reduction in government borrowing can:
A. decrease the incentive to invest.
B. increase the interest rate.
C. crowd out private investment in human capital.
D. give private investment an opportunity to expand.
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
21. When the interest rate in an economy increases, it is likely the result of either:
A. a decrease in the government's budget surplus or an increase in its budget deficit.
B. a decrease in the government budget surplus or its budget deficit.
C. an increase in the government budget surplus or a decrease in its budget deficit.
D. an increase in the government budget surplus or its budget deficit.
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
22. When the interest rate in an economy decreases, it is most likely as a result of:
A. an increase in the government budget surplus or its budget deficit.
B. a decrease in the government budget surplus or its budget deficit.
C. an increase in the government budget surplus or a decrease in its budget deficit.
D. a decrease in the government budget surplus or an increase in its budget deficit.
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
23. An increase in the government’s budget surplus will cause the interest rate to:
A. either increase or decrease.
B. remain the same.
C. increase.
D. decrease.
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
24. A decrease in the government’s budget surplus will cause the interest rate to:
A. decrease.
B. increase.
C. either increase or decrease.
D. remain the same.
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
25. If the government initiates an expansionary monetary policy at the same time that its budget
deficit decreases, then the interest rate will ______________________.
A. increase
B. either increase or decrease
C. decrease
D. remain unchanged
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
26. If the government initiates an expansionary monetary policy at the same time that its budget
deficit increases, then the interest rate will __________________.
A. remain unchanged
B. either increase or decrease
C. increase
D. decrease
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
27. A ____________________________ is one economic mechanism by which government borrowing
can crowd out private investment.
A. deficit decrease
B. smaller trade surplus
C. larger trade surplus
D. higher interest rate
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
28. If a government's budget deficits are increasing aggregate demand when the economy is
already producing near potential GDP, causing a threat of an inflationary increase in price levels,
then the central bank may react with:
A. a contractionary monetary policy.
B. an expansionary monetary policy.
C. a discretionary monetary policy.
D. a loose monetary policy.
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
29. If the U.S. economy is producing at a level that is substantially less than potential GDP and the
government's budget deficits are increasing aggregate demand, then ____________________________
is not much of a danger.
A. a tight monetary policy
B. an inflationary increase in the price level
C. international financial investment
D. the central bank's contractionary monetary policy
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
30. If the U.S. government's budget deficits are increasing aggregate demand, and the economy
is producing at a level that is substantially less than potential GDP, then:
A. higher interest rates will crowd out private investment.
B. government borrowing is likely to crowd out private investment.
C. an inflationary increase in the price level is a real danger.
D. the central bank might react with an expansionary monetary policy.
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
31. If the government’s budget deficit increases while the economy is producing substantially less
then potential GDP and expansionary monetary policy is implemented, then any ________________
from government borrowing would be _____________________________ from that monetary policy.
A. higher interest rates; largely offset by the lower interest rates
B. lower interest rates; largely offset by the higher interest rates
C. increase in interest rates; reduced by private sector investment
D. inflationary increase in price level; crowding out private investment
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
32. If a government decides to finance an investment in ________________ with higher taxes or
____________________ in other areas, it need not worry that it is crowding out private investment.
A. roads and bridges; increased borrowing
B. water supply and sewers; by raising capital spending
C. public physical capital; lower government spending
D. hydroelectric dams and windmills; government R&D
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
33. In most developed countries, the government plays a large role in society’s investment in
human capital through _________________________.
A. direct spending
B. the education system
C. tax incentives
D. private sector R&D
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
34. In a market-oriented economy, private firms will undertake most of the
_____________________________, and ________________ should seek to avoid a long series of large
budget deficits that might crowd out such investment.
A. economic growth activities; monetary policy
B. economic growth activities; fiscal policy
C. investment in human capital; monetary policy
D. investment in physical capital; fiscal policy
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Remember
35. When a business firm makes an investment in physical capital, what is that investment subject
to?
A. state and local government incentives
B. economic output and productivity
C. political orientated incentives
D. the discipline of the market
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
36. Because of the difference between the discipline imposed by market competition and the
discipline imposed by political decisions, which of the following is most likely?
A. reduced government borrowing to avoid crowding out private investment
B. difficulty managing public investment so it’s done in a cost effective way
C. government budgets will exactly shadow the rate of private investment
D. tax budgets increase without a corresponding drop in private investment
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
37. An additional investment in human capital, especially for the low-income nations of the world,
will likely directly increase which of the following?
A. productivity and economic growth
B. increased levels of R&D spending
C. consumer orientated spin-offs
D. highly qualified teachers
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
38. A government will likely ____________________________ to encourage investment in technology
R&D by private firms?
A. reduce R&D grants to nonprofit organizations
B. reduce R&D grants to universities
C. spend more on R&D in government laboratories
D. implement fiscal policy establishing tax incentives
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
39. Which of the following is least likely to benefit the civilian economy?
A. R&D carried out in government laboratories
B. R&D aimed at producing new weapons
C. direct private sector R&D spending
D. tax policy promoting civilian R&D spending
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
40. If David Ricardo's theory holds completely true, then any change in budget deficits or budget
surpluses would be completely offset by which of the following?
A. a change in currency exchange rates
B. a sustained pattern of trade imbalances
C. a corresponding change in private saving
D. a dependence on inflows of capital
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
41. Ricardian equivalence means that:
A. changes in private savings offset any changes in the government deficit.
B. changes in exports offset any changes in the government deficit.
C. changes in imports offset any changes in the government deficit.
D. changes in investment offset any changes in the government deficit.
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
42. Suppose you are analyzing data for an economy in which Ricardian neutrality holds true. If the
budget deficit increases by 50, then:
A. investment will increase by 50
B. investment will decrease by 50
C. private savings will decrease by 50
D. private savings will increase by 50
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
43. Suppose you are analyzing data for an economy in which Ricardian neutrality holds true. If
the budget surplus increases by 100, then:
A. private savings will increase by 100.
B. private savings will decrease by 100.
C. investment will increase by 100.
D. investment will decrease by 100.
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
44. A government deficit has increased from 30 to 50. The country's trade deficit is 100 and
private savings equal 65 and investment equal 90. If Ricardian neutrality holds true, after this
change in the government's budget, private savings will equal:
A. 40.
B. 105.
C. 95.
D. 85.
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
45. A government deficit has decreased from 100 to 60. The country's trade deficit is 120 and
private savings equal 80 and investment equals 100. If Ricardian neutrality holds true, after this
change in the government's budget, private savings will equal:
A. 120.
B. 70.
C. 40.
D. 140.
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
46. If an economy has a budget surplus of 400, private savings of 1,200, and investment of 1,600,
what will the balance of trade in this economy equal?
A. 0
B. deficit of 1,600
C. deficit of 1,200
D. deficit of 400
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
47. If an economy has a budget surplus of 1,500, private savings of 3,000, and investment of
5,000, what will the balance of trade in this economy equal?
A. deficit of 500
B. surplus of 500
C. surplus of 1,500
D. deficit of 1,500
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
48. If an economy has a budget deficit of 600, private savings of 2,000, and investment of 800.
What is the balance of trade in this economy?
A. deficit of 600
B. deficit of 2000
C. surplus of 2000
D. surplus of 600
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Hard
Category: Apply
49. When government policy moves from a budget deficit to a budget surplus and the trade
deficit remains constant:
A. savings will increase if investment remains constant.
B. investment will increase if savings remain constant.
C. savings will decrease, no matter what happens to investment.
D. investment will decrease if savings remain constant.
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
50. When government policy moves from a budget surplus to a budget deficit and the trade
deficit remains constant:
A. savings will decrease no matter what happens to investment.
B. savings will decrease if investment remains constant.
C. investment will increase if savings also remains constant.
D. investment will decrease if savings also remains constant.
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Understand
51. A government began 2013 with a budget deficit and a trade deficit. During the year, the
government changed its policy and is now running a budget surplus. If all other factors hold
constant, this change in policy will cause:
A. the exchange rate to decrease and the trade deficit to increase.
B. the exchange rate to increase and the trade deficit to decrease.
C. the exchange rate and the trade deficit to decrease.
D. the exchange rate and the trade deficit to increase.
Answer: C Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
52. A government began 2013 with a budget surplus and a trade deficit. Due to the onset of
recession, the government changed its policy and is now running a budget deficit. If all other
factors hold constant, this change in policy will cause:
A. the exchange rate and the trade deficit to increase.
B. the exchange rate and the trade deficit to decrease.
C. the exchange rate to decrease and the trade deficit to increase.
D. the exchange rate to increase and the trade deficit to decrease.
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
53. Which of the following is not a consequence of an increase in the government's budget
deficit?
A. private savings increases while holding everything else constant
B. exports increase while imports and all other variables are held constant
C. imports increase while exports and all other variables are held constant
D. investment falls while holding everything else constant
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Remember
54. If a government experiences an increase in its budget surplus, which of the following possible
outcomes will likely result?
A. investment falls while everything else holds constant
B. exports decrease while imports and all other variables are held constant
C. imports increase while exports and all other variables are held constant
D. private savings decrease while everything else holds constant
Answer: D Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Analyze
55. A moderate increase in a budget deficit that leads to a _____________________ is not necessarily a
cause for concern.
A. combination of less foreign capital and banks that are bankrupt
B. moderate increase in a trade deficit and a moderate appreciation of the exchange rate
C. a series of large budget deficits
D. shift in aggregate demand so far to the right that it causes high inflation
Answer: B Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Understand
56. In the U.S. economy, the offsetting effects of private saving compared to government
borrowing are typically noted as being represented by which of the following ratios?
A. much less than one-to-one
B. slightly less than one-to-one
C. slightly more than two-to-one
D. much more than two-to-one
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Medium
Category: Remember
57. _______________________________ can set the stage for international financial investors first to
send their funds to a country and cause an appreciation of its exchange rate and then to pull their
funds out and cause a depreciation of the exchange rate and a financial crisis as well.
A. Trade balance
B. Twin deficits
C. Trade deficits
D. Crowding out
Answer: A Reference:
Explanation:
Type: Multiple Choice
Difficulty: Easy
Category: Remember
Essay Questions
1. Talona's government has decided to fund its increasing budget deficit by raising capital in the
international financial capital markets. Discuss the most likely outcomes that are closely
associated this type of fiscal policy.
If the funding for a larger budget deficit comes from international financial investors, then a
budget deficit may be accompanied by a trade deficit. In some countries, this pattern of “twin
deficits” has set the stage for international financial investors first to send their funds to a country
and cause an appreciation of its exchange rate and then to pull their funds out and cause a
depreciation of the exchange rate and a financial crisis as well.
Reference:
Explanation:
Type: Essay
Difficulty: Hard
Category: Apply
2. Identify the negative macroeconomic outcomes that a government risks when it continues a
sustained pattern of large budget deficits over time.
A sustained pattern of large budget deficits over time risks causing several negative
macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary
increase in the price level; crowding out private investment in physical capital in a way that slows
down economic growth; and creating a dependence on inflows of international portfolio
investment which can sometimes turn into outflows of foreign financial investment that can be
injurious to a macroeconomy.
Reference:
Explanation:
Type: Essay
Difficulty: Medium
Category: Understand
3. The Tulu Island economy is experiencing an inflow of foreign investment capital associated with
a trade deficit. Foreign investors are making long-term direct physical capital investments in
Tulu's business community at a record pace. Relate whether there is cause for concern in this
case, and briefly explain your answer.
If a nation is experiencing the inflow of foreign investment capital associated with a trade deficit
because foreign investors are making long-term direct investments in firms, there may be no
substantial reason for concern. In this case, the inflows of foreign investment capital and the trade
deficit are attracted by the opportunities for a good rate of return on private sector investment in
an economy.
Reference:
Explanation:
Type: Essay
Difficulty: Medium
Category: Apply
4. Talona's economy is experiencing an inflow of foreign investment capital associated with a
trade deficit. Foreign investors are avoiding making long-term direct physical capital investments
in Talona's firms. Relate whether there is cause for concern in this case, and briefly explain your
answer.
In this case, the is cause for concern regarding the danger that arises in particular when the inflow
of foreign investment capital is not funding long-term physical capital investment by firms, but
instead is short-term portfolio investment in government bonds. Foreign financial investors will
be on the alert for any reason to fear that the country’s exchange rate may decline or the
government may be unable to repay what it has borrowed on time. A relatively small piece of bad
news about an economy can trigger an enormous outflow of short-term financial capital
Reference:
Explanation:
Type: Essay
Difficulty: Medium
Category: Apply
5. Briefly explain what a change in any part of the national saving and investment identity points
out.
A change in any part of the national saving and investment identity points out that if the
government budget deficit changes, then either saving, private investment in physical capital or
the trade balance—or some combination of the three—must change as well.
Reference:
Explanation:
Type: Essay
Difficulty: Easy
Category: Understand
6. From a macroeconomic point of view, identify all of the possible sources for funds available to
governments when they are borrowers in financial capital markets.
When governments are borrowers in financial capital markets, there are three possible sources for
the funds from a macroeconomic point of view: (1) households might save more; (2) private firms
might borrow less; and (3) the funds might come outside the country, from foreign financial
investors.
Reference:
Explanation:
Type: Essay
Difficulty: Easy
Category: Understand
7. In algebraic terms, contrast the national savings and investment identities noted below:
1) Private savings + Trade deficit + Government surplus = Private investment
2) Private savings = Private investment + Government budget deficit + Trade surplus.
1) S + (M – X) + (T – G) = I
2) S = I + (G – T) + (X – M)
Reference:
Explanation:
Type: Essay
Difficulty: Hard
Category: Understand
8. Identify and briefly discuss the underpinnings of economic growth, including examples.
The underpinnings of economic growth are investments in physical capital, human capital, and
technology, all set in an economic environment where firms and individuals can react to the
incentives provided by well-functioning markets and flexible prices. Examples include government
spending on publicly owned physical capital like roads or water systems, on education that
creates human capital, or on research and development that creates new technology.
Reference:
Explanation:
Type: Essay
Difficulty: Medium
Category: Understand
9. Briefly discuss the macroeconomic benefits of a highly educated and skilled work force and
then explain how government could do more to encourage increased R&D activities.
A highly educated and skilled workforce contributes to a higher rate of economic growth, and
especially for the low-income nations of the world, an additional investment in human capital
seems likely to increase productivity and growth.
Government could spend more on the R&D that is carried out in government laboratories, as well
as expanding federal R&D grants to universities and colleges, nonprofit organizations, and the
private sector. Fiscal policy can also support R&D through tax incentives, which allow firms to
reduce their tax bill as they increase spending on research and development.
Reference:
Explanation:
Type: Essay
Difficulty: Medium
Category: Understand
10. Explain why it is hard to draw a general lesson about how much government investment in
physical capital will benefit the economy. Contrast a firm making an investment in physical capital
with the government financing an investment in public physical capital.
It is hard to draw a general lesson about how much government investment in physical capital will
benefit the economy, because government responds to political incentives as well as to economic
incentives. When a firm makes an investment in physical capital it is subject to the discipline of
the market: if the firm doesn’t receive a positive return on its investment, the firm may lose money
or even go out of business. Managing public investment so that it is done in a cost-effective way
can be difficult, because the discipline imposed by political decisions is different than the
discipline imposed by market competition. If a government decides to finance an investment in
public physical capital with higher taxes or lower government spending in other areas, it need not
worry that it is crowding out private investment. However, if a government decides to finance an
investment in public physical capital by borrowing, it may end up increasing the quantity of public
physical capital at the cost of crowding out investment in private physical capital.
Reference:
Explanation:
Type: Essay
Difficulty: Hard
Category: Apply
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