Question

There is initially a balanced budget when G declines $100. Explain and diagrammatically represent what happens to r, S, C, I, and Yd. For the variables S, C, I, and Yd, identify what happens to the direction of the variable and to the magnitude.

Answer 1

balanced budget multiplier is the change in aggregate output led by an equal change in government purchases and taxes to keep budget deficit and surplus unchanged. It is always equal to unity which means that the change in taxes the additional change in aggregate output due to change in government purchases. So, balanced budget multiplier is a sum of expenditure multiplier and tax multiplier.

An autonomous decline in government spending would shift the aggregate demand curve downwards and aggregate output would fall, while an equal decline in autonomous taxes will shift aggregate demand to the right and increase output. In such a case a policy designed to strike a balance in the economy. Initially a decline in government spending would induce a budget deficit and reduce equilibrium output which means less tax revenues will be generated implies disposable income will increase for a given level of income aggregate demand will decrease which causes reduction in equilibrium GDP.

Note that government can generate tax revenues autonomously or at a given tax rate.

The whole process is explained in the picture below:

Hence, the equilibrium GDP will decline by the amount of initial decline in government spending.i.e.$100 whereas the induced change in aggregate demand would be offset by the autonomous decline in taxes by same amount as decline in government purchases.

the diagram is as given below: