Assuming the government of a typical economy decides to reduce their fiscal deficit by executing a fiscal deficit reduction (or rather contraction fiscal policy).

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?

Solutions

Expert Solution

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.

Rahul Sunny answered 1 year ago

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