Suppose the government proposes austerity measures that induce a larger reduction in public goods. We are...

Suppose the government proposes austerity measures that induce a larger reduction in public goods. We are going to use our standard one-period model to address the effects of this shock. Let a representative consumer maximize utility which is a function of consumption, c, and leisure, l. The consumer earns a wage rate, w, receives profits, π, and pays a lump sum tax T. They are endowed with a maximum of h units of time. A representative firm maximizes profits by choosing labor. The government uses the collected taxes to finance government consumption, G, under a balanced budget.

1. Using a graph draw the model in competitive equilibrium.

2. On the same graph draw the new equilibrium with austerity measures in place.

3. What are effects of austerity on consumption, labor, and aggregate output.

Expert Solution

a)

The figure above gives the competitive equilibrium in the economy.

The consumer’s budget constraint is given by ADC where the BC is no labor income net of tax T. The curve -G₀aEc is the PPF of the economy. The consumer preference for consumption and leisure is given by the IC labeled I₁. The -G₀ is the government spend on total output Y. The highest the consumer can consume is OC. OC+OG₀ is the total output. The consumer equilibrium occurs where the IC touches the budget line at E. At E, the consumer works for (h-l₀) hours and receives the wage w. the total output is C₀+G₀ .

b)

Now let the government take up the austerity measures. The austerity measures are decreasing government spending and/or increasing tax at the same time. The fall in government spending decrease G₀ to G₁ , and the PPF shifts upward by the amount of change in G to -G₁bE'C'. The decrease in government spending increases the profit of the firm as productive capacity remain intact and the government spends less. This shift the budget line up to A'B'C. The new equilibrium occurs to E'. At E' the consumer spend l₁ hours in leisure and consume C₁.

c)

Therefore, the austerity increases consumption, and decreases output as leisure rises and people spend fewer hours working.

Rahul Sunny answered 1 year ago

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Suppose the government proposes austerity measures that induce a larger reduction in public goods. We are...

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