If an increase in government spending is matched by an equal increase in lump-sum taxes, output rises by the amount of the increase in government spending. Why?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Spending raises income directly and through the multiplier chain, but the tax rise works only through consumption
A rise in G adds to spending at once, and then again round after round. A tax rise cuts spending only through consumption, and only by c times the tax in the first round. So the tax effect is smaller by the whole first round, ΔG, and income rises by ΔG.
The tax rise does cut consumption, and investment does not change here. The two multipliers also do not cancel out: the tax multiplier is one less in absolute value, so income still rises by ΔG.
NCERT (2026-27): “Box 5.1: Fiscal Policy … To see why the balanced budget multiplier is 1, we examine the multiplier process. The increase in government spending by a certain amount raises income by that amount directly and then indirectly through the multiplier chain increasing income by …” “But the tax increase only enters the multiplier process when the cut in disposable income reduces consumption by c times the reduction in taxes. Thus the effect on income of the tax increase is given by …” “The difference between the two gives the net effect on income. Since ΔG = ΔT, from 5.10 and 5.11, we get ΔY = ΔG, that is, income increases by the amount by which government spending increases and the balanced budget multiplier is unity. …” |