Question

Governments may wish to increase output without running a budget deficit. The question is whether policy changes in government spending G and net taxes T that maintain a balanced budget can result in changes in economic output Y. To start, consider the equilibrium condition in the goods market, given by 1. a) By how much does Y increase when G increases by one unit? b) By how much does Y decrease when T increases by one unit? c) Why are the answers to part (a) and part (b) different? d) Assume that the government starts with a balanced budget, G-T, and that it increases both G and T by one unit in an attempt to increase output. Using your answers to parts (a) and (b). what is the change in equilibrium output? Are balanced budget changes macroeconomically neutral? e) How does the propensity to consume affect your answer? Why?

Answer 1

C) the answer in part a and b differs because government spending affects the demand directly, whereas the taxation affects demand indirectly through consumption.

D) Balanced budget changes are not macroeconomically neutral.

E) The propensity to consume does not effect the answer. It is because the balanced budget tax increase stops the multiplier process. Both Y and T increase by one unit. Therefore disposable income and consumption do not change.