Consider the following statements: 1. An additional spending by the Government of ₹ X is likely to have less impact on income than an additional transfer of ₹ X to households. 2. 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?

Correct: B, 2 only. Statement 1 has the ranking the wrong way round. A rupee the government spends is itself a rupee of demand, and only then does it get re-spent by whoever receives it; a rupee transferred to households first has to survive their decision to save part of it. In the simple Keynesian model the government-spending multiplier is 1/(1−c) while the transfer multiplier is c/(1−c), where c is the marginal propensity to consume. Since c is less than one, spending beats transfers, not the other way round. Statement 2 is the standard monetary-accommodation result. A fiscal expansion raises income, which raises the demand for money; with the money supply held fixed the interest rate must rise, and the higher rate squeezes out interest-sensitive private investment. That crowding out cuts the net gain in income, so the same spending does less work when the money supply is not allowed to expand alongside it.

Why the others are wrong

• (a)
  1 only: Keeps the inverted statement and drops the sound one. Direct government purchases add to demand in full; transfers add only the part households choose to spend.
• (c)
  Both 1 and 2: Statement 2 is right, but statement 1 reverses the standard multiplier ranking, so 'both' fails.
• (d)
  Neither 1 nor 2: Rejects the crowding-out point, which is exactly what the IS–LM framework predicts when a fiscal expansion is not accommodated by money growth.

The expenditure multiplier measures how much equilibrium income rises per rupee of autonomous demand. Government purchases enter demand directly, giving a multiplier of 1/(1−c). A transfer payment enters only through household consumption, so its first-round effect is c rupees and its multiplier is c/(1−c): smaller by exactly one unit of the spending multiplier. Whether the full multiplier is realised then depends on the monetary side: in IS–LM, a rightward shift of the IS curve along an upward-sloping LM curve raises both income and the interest rate, and the interest-rate rise partly offsets the expansion.

Key facts

• Government-spending multiplier = 1/(1−c); transfer (or tax) multiplier = c/(1−c), where c is the marginal propensity to consume.
• The two differ by exactly 1, which is why a rupee of purchases always beats a rupee of transfers in the simple model.
• In IS–LM, an unaccommodated fiscal expansion raises the interest rate and crowds out private investment, reducing the realised multiplier.
• A flatter LM curve (money supply expanding with income) leaves more of the multiplier intact; a vertical LM curve leaves none of it.

Common traps

• Assuming transfers are more powerful because the money 'reaches people directly': the first round is smaller, not larger.
• Forgetting that the balanced-budget multiplier equals one, which is a third distinct case.
• Reading 'expansion in money supply' as inflation rather than as the accommodation that prevents the interest rate from rising.

No directly related past PYQ was found.

• practice, not a real PYQ

  In the simple Keynesian model, if the marginal propensity to consume is 0.8, the government-spending multiplier is

  • (a)0.8
  • (b)4
  • (c)5
  • (d)8
  Answer(c) 5: the multiplier is 1/(1−c) = 1/(1−0.8) = 5; the transfer multiplier would be c/(1−c) = 4.
• practice, not a real PYQ

  A fiscal expansion that is not accompanied by any increase in the money supply will typically

  • (a)raise the interest rate and crowd out private investment
  • (b)lower the interest rate and crowd in private investment
  • (c)leave the interest rate unchanged
  • (d)reduce national income below its initial level
  Answer(a) raise the interest rate and crowd out private investment: higher income raises money demand against a fixed supply, pushing rates up.