For both political and macroeconomic reasons, governments are often reluctant to run budget deficits. Here, we examine whether policy changes in G and T that maintain a balanced
budget are macro economically neutral. Put another way, we examine whether it is possible
to affect output through changes in G and T so that the government budget remains balanced.
Start from this equation: Y = Co + ci(Y – T) + I +G;
(a) By how much does Y increase when G increases by one unit? [4mks]
(b) By how much does Y decrease when I increases by one unit? [4mks]
(C) Why are your answers to parts (a) and (b) different? [4mks]
Suppose that the economy starts with a balanced budget: T = G. If the increase in G is equal
to the increase in T, then the budget remains in balance. Let us now compute the balanced
budget multiplier.
(d) Suppose that both G and T increase by one unit. Using your answers to (a) and (b), what
is the change in equilibrium GDP? Are balanced budget changes in G and T
macro economically neutral? [4mks]
(e) How does the specific value of the propensity to consume affect your answer to part (d)
Why? [4mks]
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