a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of reducing a government's budget deficit by reducing government purchases. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and. the terminal equilibrium values. b. State in words what happens to: i. the real interest rate;ii. national saving; iii. investment; iv. consumption; and v. output
real interest rate decreases, national saving increases, investment increases, consumtion is unchhanged, output is unchanged (fixed because it is determined by the factors of production).
Since the government will reduce its spending level, that will result in:
decrease in the interest rate since the government will not need to borrow money (or it will need to borrow less)
national savings will increase since the deficit decreases
investment (= national savings) will increase due to the lower interest rates
in the long run consumption remains unchanged but in the short run it will decrease because aggregate demand decreases (aggregate demand will decrease by change in G / MPS), but soon consumption increases back
output is unchanged because the factors the factors of production remain unchanged (only a technological breakthrough would increase it)
