Question

Suppose the government decides to reduce both government expenditures and taxes by the same amount (this is a “balanced budget” change). What happens to: (i) national saving; (ii) the real interest rate; (iii) investment; (iv) consumption; and (v) output? Illustrate graphically using the The loanable funds market graph and explain in words why these variables change or why they do not change.

Answer 1

Since it is a balanced budget, there is no change in public saving. There is no deficit or surplus which implies that loanable funds market experiences no change. Hence real interest rate remains unchanged. As a result there is no change in private investment

However since balanced budget multiplier is 1, aggregate demand shifts to the left by the size of reduction in government spending. This results in decreasing the real GDP and the rate of inflation in the short run. Consumption therefore reduces.

Hence, (i) national saving does not change; (ii) the real interest rate does not change; (iii) investment does not change; (iv) consumption reduces; and (v) output reduces