Question

Consider the following static (closed-economy) version of the Classical model:

Y = F (K, L)

C = A + a(Y − T ), with A > 0 and 0 < a < 1,

I = B − br, with B, b > 0,

where A and B represent respectively the autonomous components of consumption (C) and investment (I). Assume the factor inputs, K (capital) and L (labor), are fixed in supply. Finally, assume that government expenditures (G) and taxes (T) are exogenously given. [50 points; 25 each]

(a) Predict and explain the effects of an exogenous increase in government spending (dG > 0) on the interest rate (r), equilibrium output (Y ) and the composition of output.

(b) Now suppose there exists a balanced-budget rule that requires T= G. This requirement, in turn, implies that dT = dG. Predict and explain how does this balanced budget requirement affects the predictions you made above in part (a) regarding the effects of an exogenous increase in government expenditures (dG > 0) on the interest rate (r), equilibrium output (Y ) and the composition of output.

Answer 1

. Ina closed economy, agg demand is equal to the agg supply they ys - yd = c+I+G G = Exogenous value. C = At aly-T) AYO ; ocakl I= B- bro B, by on = { At a CY-T7+[B- bro] G. [(A + BIG -AT) / co-a)] - 16/(1-2)] r. AY = TMPC AG & The dor. A herre AG = dito angend of w An autonomous increase in gort spending will have multiple expansion on National income. ctith A Crone = CAS Cat II + G2 Ichthota cit I it Get bony w bial doyo - daxo? | AG as L P. 44 92 toal income and this expansionary govt spending in the public expenditure, due to crowding out effect, if gort finances its extra spending through boronowing, I real interest rate will go up along with increasing output and income.

let the govt increases tax by the same amt as increase in the goxt spending this dt = dG Changein LT XO! 12 by AY = - MPC - MPC MAY = ta dai + (- aj ditt AY = d' GE AT al. oin. they ; due to balanced budget mule, often increase in goxt speding, tax (same ant as gort spending) is imposed, as the balance budget multiplien ist, that means the multiplien effect of a change in tax offsets all but the initial prodn. by the gort spending. this an increase in agg prod and income by govt spending is offset by a decreasing agg prood income due to increase in tax fe sono pribani