Question

However, if the tax bill is unable to cut taxes for the middle class but reduces government expenditure, how would your answer to 2a) (2a:If the tax bill cuts taxes for the middle class, how will this affect the real economy and the forex market? Explain with the help of a graph.) above change? Answer in words and graphs.

Answer 1

Effect of reducing government expenditure on the real economy, given the tax constant

A one-line theory to understand this is as follows:

Reduce spending/expenditure -> Less government money pumped in the economy -> Low economic growth

Let's understand this by GDP point of view. As you know, in the formula: C + I + G + (Ex -lm), if any of the factor increases, the GDP increases. If the "G" portion, i.e. the government spending at any point increases, GDP increases and if it decreases, GDP decreases. The reduced expenditure can at a time reduce the government budget deficit, but simultaneously it hits the economic growth, aggregate demand and long-term productivity.

Effect of reducing government expenditure on the real forex market, given the tax constant

The exchange rates appreciate on reduction of government expenditure and also on an increase in government purchases. When the government spends less, this leads to a shortage of demands, which ultimately lowers the overall prices of goods and services. As the prices decrease, this also makes exports of our goods to other countries less expensive and imports more unattractive. This leads to lower demand for foreign currency and increased demand for domestic currency to purchase domestic goods. This increases the exchange rates.

I have attached the graph depicting the effect of reducing expenditure on the economy. Have a look at it. For the second part, it's a direct relationship.

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