Question

Question 2 Consider a small closed economy. The government wants to reduce the budget deficit by reducing its spending. a. Use the goods market and IS curve to illustrate graphically the impact of the reduction in government spending on output. b. Now use the goods market and money market diagrams and the IS-LM model to illustrate graphically the impact of the reduction in government spending on output c. Why the effect of the reduction in government spending on output is different in part a from that in part b?

Answer 1

2)

a) Goods market equation is given by:

Y = C(Y) + I + G ;

C is consumption which is a function of income.

I is investment and G is government spending.

Reduction in G obviously results in reduction in Y as we understand from the equation. We will see in the following graph as well.

As expected the output goes down from Y0 to Y1.

b) Now as we see from the previous diagram that interest rate has come down to r1 from r0.

Money market equation is given by : M/P = kY - hr ; M is money supply, P is price level, Y is income and r is interest rates

k and h are respective marginal propensities.

With decrease in, hr component decreases resulting in increase in (M/P) [Mathematical intuition]

So, LM curve shifts RIGHTWARD.

As seen from the diagram, output increases to Y3 from Y1.

Y3 still is at a lower level than Y0 .

Equilibrium s achieved at r3 and Y3 levels.

c) In part a , the effect is only considered from goods market aspect. When the policy measure is taken, it also has an indirect impact on the money market and it takes a little time to reach equilibrium. When Money market effects is also considered, the output and interest levels adjust accordingly and reach equilibrium.