Question

Use the classical model for determining the long-run outcome of the economy to answer the following question. Suppose a government in debt crisis (such as Greece) moves to reduce its budget deficit by reducing the annual funding for tertiary education and healthcare drastically.

(a) Graphically illustrate the impact of such a reduction in the government's budget deficit:

i. First, by assuming that the total factor productivity (TFP) does not depend on the government spending on health and education.

ii. Second, by assuming that the TFP increases with government spending on health and education but by a limited amount. [Be sure to label: the axes; the curves; the initial equilibrium values; the direction curves shift; and the terminal equilibrium values.]

(b) State and explain in words what happens to the real interest rate, national saving, investment, consumption, and output.

(c) Discuss the likely impact of such policy on the inequality of income between the educated and uneducated labour. Support your answer with graphical illustrations.

(d) Suppose the above policy causes a sudden emigration of workers with no education to neighbouring countries for easier access to education and health facilities. Assume TFP does not decrease following the government policy shock, as in part a (i), and following the labour migration. How would your answer to (b) and (c) change?

Answer 1