For both political and macroeconomic reasons, governments are often reluctant to

Question

For both political and macroeconomic reasons, governments are often reluctant to run budget deficits. Here, we examine whether we examine whether it is possible to affect output through changes in government spending and taxes while the bu1dget remains balanced.
Output is given by:
??=1???1 (??0+??+?????1??)
1. By how much does Y increase when G increases by one unit?
2. By how much does Y decrease when T increases by one unit?
3. Why are your answers to (1) and (2) different?
Suppose that the economy starts with a balanced budget G=T.
4. Suppose that G and T increase by one unit each. Using your answers to 2 and 3 what is the
change in equilibrium GDP? Are balanced budget changes in G and T macroeconomically
neutral?
5. How does the specific value of the propensity to consume affect your answer? Explain.

Explanation / Answer

1.In the goods market equilibrium, Y = c0 + c1(Y – T) + I + G = Z (equation 3.7), and Y = [1/ (1 – c1)] [c0 + I + G + c1T] 1/ (1 – c1) is the multiplier, so Y increases by 1/ (1 – c1) when G increases by one unit. 2. c1/ (1 – c1) is the tax multiplier, so Y decreases by c1/ (1 – c1) when T increases by one unit. 3. The answers differ because government spending affects demand directly, but taxes affect demand through consumption, and the propensity to consume is less than one. 4. The change in Y equals 1/ (1 – c1) – c1/ (1 – c1) = 1. Balanced budget changes in G and T are not macroeconomically neutral. 5. The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier process. Y and T both increase by on unit, so disposable income, and hence consumption, do not change.

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