Question

Suppose a government decides to reduce spending and (lump-sum) income taxes by the same amount. Using the long-run model of the economy, graphically illustrate the impact of the equal reductions in spending and taxes. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. The direction the curves shift; and v. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and v. output.

Answer 1

AD = C+I+G+X-M

a) When government spending falls, AD shifts leftward to AD1 taking the equilibrium to E1,as government spending and AD have direct relationship with each other. But if the lump sum tax also have fallen, it would raise the disposable income income of individuals in the economy and raise the AD to such an extent that it is even more than the initial level. Thus it shifts to AD2 taking the equilibrium to E2.

b) As overall aggregate demand rises which shifts the IS curve to its right. Shifting IS curve to its while LM remains the same, raises the interest rate.

As the disposable income have risen, savings would rise as consumption would rise slightly.

Investment would falls as interest rate have risen.

Consumption would rise as disposable income have risen.

Output have risen to Y2