Sub: Economics Topic: Macro Economics
Question:
Suppose Congress wishes to reduce the budget deficit by reducing government spending.
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Use the IS-LM model to illustrate graphically the impact of the reduction in government
spending on output and interest rates. (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.)
Solution:
The balanced budget multiplier =1
Balanced budget multiplier is a measure of the change in aggregate production caused
by equal changes in government purchase and taxes. This multiplier is the combination of the
expenditures multiplier, which measures the change in aggregate production caused by
changes in an autonomous aggregate expenditure, and the tax multiplier which measures the
change in aggregate production caused by changes in taxes.
In this case the expenditure multiplier is 1/1-MPC= 1/0.25=4
Tax multiplier= -MPC/ 1-MPC= -0.75/ 0.25= -3
∆Y/∆G = 4
2600/4= ∆G
650=∆G
Government expenditure should increase by 650
∆Y/∆T = 3
2600/3= ∆T
∆T = -866.66
Thus tax should decline from 1000 to 866.66
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Sub: Economics Topic: Macro Economics
In case of balanced budget multiplier the government expenditure should increase by
650 and the tax should decrease by (1000- 866.66) = 133.34 to restore the full employment.
** End of the Solution **
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*The Homework solutions from ClassOf1 a re intended to help the s tudent understa nd the approa ch to sol vi ng the problem and not for submi tting the same in
lieu of your a cademic submissions for grades .