Question

In the Keynesian model, a decrease in government purchases affects output by

1. decreasing labor supply, because workers feel effectively poorer.

2. decreasing saving to pay for future taxes, lowering the real interest rate and shifting the IS curve to the left.

3. decreasing the real interest rate due to crowding out, reducing aggregate demand.

4.decreasing aggregate demand as national saving declines.

Answer 1

Answer: Option 2: decreasing saving to pay for future taxes, lowering the real interest rate and shifting the IS curve to the left.

A decrease in government spending results in a decrease in aggregate demand, lower interest rates and thus results in lesser national income and national savings as a consequence.

When Government spending reduces, the IS curve shifts leftward, indicating lower interest rates as well lower output levels (RGDP)

In the above diagram, IS curve shifts to the left and real interest rates fall from R to R1 and output falls from Q to Q1.

With a reduction in government, there is a fall in real interest rates and the level of output in the economy. With a fall in RGDP, income reduces and so does the national savings. With lesser income, less tax is paid as a direct result. There is also a slowdown in the economy as government spending and purchases affect market demand, and a reduction in spending results in a reduction in aggregate demand.