Reducing Government Spending Assignment Paper
Consider an economy described as follows: This economy is currently experiencing a budget deficit equal to 400 . a. In this economy, compute public saving, private saving, and national saving. b. Find the equilibrium interest rate. c. Suppose this country’s legislature passes a balanced budget amendment requiring government spending to equal net taxes. Find the new equilibrium interest rate under each of the following two options: a. Option I: Balance the budget by changing taxes b. Option II: Balance the budget by changing government spending Under which option will real interest rates be higher, and investment lower? Reducing Government Spending Assignment Paper
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Step-by-step
Step 1/2
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Solution:-
a. In this economy, we can find public saving, private saving, and national saving as follows:
- Explanation for step 1
Public saving (S_public) = T – G = 0 – 3,000 = -3,000 Private saving (S_private) = Y – T – C = 14,000 – 0 – 1,000 – 0.8(Y – 0) = 13,000 – 0.8Y National saving (S_national) = S_public + S_private = -3,000 + (13,000 – 0.8Y) = 10,000 – 0.8Y
b. To find the equilibrium interest rate, we need to set investment equal to national saving:
- Explanation
I = S_national 1,900 – 70r = 10,000 – 0.8Y Substituting Y = 14,000 and simplifying, we get: r = (1,900 – 10,000 + 0.8(14,000)) / 70 = 6%
Therefore, the equilibrium interest rate is 6%.
Step 2/2
c. Suppose the government passes a balanced budget amendment requiring government spending to equal net taxes. Then we have: Option I: Balance the budget by changing taxes If the government balances the budget by changing taxes, then G = T. The new public saving will be: Reducing Government Spending Assignment Paper
Explanation
S_public = T – G = T – T = 0 Private saving remains the same, so the new national saving will be: S_national = S_public + S_private = 0 + (13,000 – 0.8Y) = 13,000 – 0.8Y
Equating investment with national saving, we get:
I = S_national 1,900 – 70r = 13,000 – 0.8Y Substituting Y = 14,000 and simplifying, we get: r = (1,900 – 13,000 + 0.8(14,000)) / 70 = 10%
Therefore, the new equilibrium interest rate under option I is 10%. Option II: Balance the budget by changing government spending
If the government balances the budget by changing government spending, then T = G + 400. The new public saving will be: S_public = T – G = (G + 400) – G = 400
Private saving remains the same, so the new national saving will be: S_national = S_public + S_private = 400 + (13,000 – 0.8Y) = 13,400 – 0.8Y
Equating investment with national saving, we get: I = S_national 1,900 – 70r = 13,400 – 0.8Y Substituting Y = 14,000 and simplifying, we get: r = (1,900 – 13,400 + 0.8(14,000)) / 70 = 5% Therefore, the new equilibrium interest rate under option II is 5%. Under option I, real interest rates are higher and investment is lower than under option II. This is because increasing taxes reduces disposable income, which in turn reduces consumption and investment. On the other hand, reducing government spending leaves more disposable income in the hands of consumers and investors, stimulating consumption and investment. Reducing Government Spending Assignment Paper