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.

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

Answer 1

In long run, AS is vertical while AD is downward sloping. If AS remains the same and AD shifts leftwards due to decreased government spending, output would remain same at Y but price would falls from P to P1.

a) As government reduced their expenditure in the economy, they would love to raise other investments in the economy, for that they will decrease the interest rate.

National Savings effect is ambiguous as consumption have risen due to price fall but we do not know how much fall in price lead to how much rise in consumption. Lets say there is 10% reduction in price which only raised consumption by 5%, this raised the savings by 5%

Investments will rise as interest rate have fallen.

Consumption would rise as price fallen.

Output would remain the same.

b) As government expenditure on education and health sector have fallen, people with less education will face more difficulties compared to employed labor as government helps achieving employment, education to unemployment people to raise employment rate in the economy. This decreased aggregate demand would raise the inequality between educated and uneducated.

c) If emigration to the country rises of workers with no education and health care facility.

c (a)Real interest rate would fall more as more people are there in the economy who are unemployed. Government would give them lesser interest rate to invest more in the economy.

National saving would fall as more people are into the economy. Those who just entered have no access to earn income which would overall decline the national saving rate.

Investment will rise even if a small portion of newly came people are good in raising business.

Consumption would fore sure rise as more people are there to consume goods.

Output would have to rise in long run as AS would have shift to right.

c (b) Coming more uneducated people in the country would raise the inequality more in the country between uneducated and educated people. As uneducated people would put pressure in the society while educated one will get jobs and start working which raise the gap.