Question

Assuming the government of a typical economy decides to reduce their fiscal deficit by executing a fiscal deficit reduction (or rather contraction fiscal policy). Based on your understanding of the concept Investment = Savings + (Tax - Govt. Spending) or I = S + (T-G) in an economy as well as spending multiplier, how will such decision by the government impact the level of investment, savings and output level (or income level) in the economy?

Answer 1

Impact on investment:

If government expenditure decrease then, investment would increase.

I=S +(T-G), in this equation relation between government expenditure and investment is negative, which means if G increases, I decreases or vice versa. Hence, investment would increase due to decrease in Government expenditure.

Impact on savings:

Rearranging the above equation, we get

S= I+ (G-T)

From this we can say there is a positive relation between savings and government expenditure,G. Hence, when government expenditure increase, savings increase or vice-versa. Hence, savings would decrease if government expenditure decrease due to contractionary fiscal policy.

Impact on output:

Y= C+ I+ G

From above equation, we can see there is a positive relation between output,Y and government expenditure, G. So, when government expenditure decreases, output decrease or vice-versa. Hence, output would decrease due to contractionary fiscal policy.