Assume a closed economy modeled by the following relations: (1) C = 0.75(Y - T)

Question

Assume a closed economy modeled by the following relations: (1) C = 0.75(Y - T) + 50 (2) T = 0.20Y (3) I = -5,000r + 300 (4) ^{}M(DEMAND)/P = 0.2Y - 2,500r + 100 (5) M(SUPPLY) = M* = fixed

Given the state of its budget, the Government decides to decrease its public spending by 8%.

5- Following question 4-, an economic expert suggests to combine the public spending reduction (performed at question 4-) with a 5%-increase of money supply. Using the economic reasoning based on the dynamics of the (IS) and (LM) curves, intuitively (i.e. no computation) explain the logic of this suggested policy. Then, by computing the new equilibrium values of endogenous variables, verify if this logic is correct, particularly regarding the extent to which the Government now respects the lower-than-3% deficit-toGDP fiscal rule.

Explanation / Answer

Answer. A reduction in government spending causes a fall in interest rates and decreases income level.

Deficit must be less than 3% of GDP

(G-T) < 0.03Y

If government reduces spending by 8%, then new spending will be 230. By plug in the values of G=230 in the IS-LM equations we will get new Equlibirm values.

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