Balanced Budgets: Suppose that the government passes a balanced budget law. This

Question

Balanced Budgets: Suppose that the government passes a balanced budget law.

This law - known in popular media as pay-as-you-go - requires the government to

meet any increase in government spending with an increase in taxes i.e. G "= T ".

This question will analyze the consequences of this law on the macro economy

under classical assumptions.

Consider the following Economy

Y = C + I + G

C = c0 + c1(Y - T)

I = I0 - I1r

G = _G

T = _ T

a) An increase in government spending and taxes represent a change in the demand for output. Under classical assumptions supply creates its own demand. Therefore, what is the impact of a change in taxes and government speding on output?

b) What market do you expect to be affected by a change in government speding under a balanced budget rule?

c) Assume that government increases spending to fund social security, which implies that taxes go up by an equal amount, what effect will this have on the real interest rate?

d) How does your answer depend on the marginal propensity to consume?

Explanation / Answer

A) Look at the equation y = c+i+g..

An increase in g will lead to an increase in y.

Now look at secong equation c will remain unchanged because the increase in g is equal to increase in t and so the effect will be nullified. So in all y increases by the amount of increase in G. So the change in taxes and government spending will have a direct impact on output. The ouput will also change by the same amount.

B) A highly competitive perfect market that is the market in which there is perfect competition will be affected by this rule as a change in G or T would lead to a change in demand and subsequently the equilibrium will shift.

C)Interest rate depends on the investment I. An increase in the taxes will lead to a lower investment and thus the interest rate will rise if government increases spending to fund social security.

D)The coefficient C1 represents the marginal propensity to consume. If C1 increases the overall consumption C which in turn will increase Y. So MPC will lead to an increase in output Y not it will not have any impact on the real interest rates.

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.