Suppose the government increases its expenditures with no change in taxes. Use the Keynesian cross diagram...

Suppose the government increases its expenditures with no change in taxes. Use the Keynesian cross diagram (the ZZ-Y diagram) to illustrate graphically and explain verbally what happens to equilibrium output in the goods market.

Now use the ISLM model to illustrate graphically and explain verbally what happens to equilibrium income, the interest rate, and investment. Clearly explain the effects on investment.

What would happen to equilibrium output if the increase in government expenditures was matched by an equal increase in taxes (like under a balanced budget rule)? No need to draw any graph for this part; just explain verbally.

Expert Solution

(a)

When government spending rises, planned aggregate expenditure (PAE) increases, shifting the PAE line upward, increasing both equilibrium aggregate demand and output.

In following graph, an increase in government spending from G0 to G1 shifts the PAE line upward from PAE0 to PAE1, increasing equilibrium output from Y0 to Y1.

(b)

Higher government spending shifts the IS curve rightward, which increases interest rate and output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. Increase in government spending shifts IS0 rightward to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1.

(c)

If increase in government spending (causing output to increase) is equal to an increase in taxes (causing output to decrease), net effect will be an increase in output, because government spending multiplier is higher than the absolute value of tax multiplier. Therefore, increase in output due to higher government spending will be higher than the decrease in output due to higher tax.

Rahul Sunny answered 1 year ago

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