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IAI Actuarial Core Principles · Business Economics · Impact of macroeconomic policies on businesses

The government of India raises its spending on road construction, financed by borrowing, while the economy has substantial spare capacity. Which effect on private firms is most likely in the short run?

Higher demand for construction-linked firms and their suppliers, with little crowding out. When an economy has spare capacity, borrowing-financed government spending lifts aggregate demand and output without much pressure on interest rates or on private investment.

  1. AHigher demand for construction-linked firms and their suppliers, with little crowding out of private investmentCorrect
  2. BComplete crowding out of private investment because interest rates must rise sharply
  3. CA fall in aggregate demand because borrowing reduces the money supply to zero
  4. DNo change in firm output because government spending is not part of aggregate demand
  5. A fall in the price level because government spending reduces costs for all firms

Explanation

With spare capacity, extra government spending raises demand and output, particularly for construction firms and their suppliers. Crowding out is weak because resources are idle. Full crowding out occurs only near full employment, so that option is wrong.

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