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Keynesian cross diagram

Question 2
Suppose that initially the goods and services market is in equilibrium at the potential (full-employment level) of output and that the government budget is balanced, that, is government spending equals tax revenues.
a. Now suppose that because of headwinds from a credit crunch, consumption and investment fall. Also suppose that the government does not change its spending or taxation policies. What will be the effect on the budget gap, that is, on the difference between government spending and tax revenues? Explain.
b. Suppose that the government has a law that the budget must be balanced at every level of income. How must it respond to the credit crunch? Is this a good law? Explain and illustrate graphically with a Keynesian cross diagram.

Solution Preview

a. Initially the goods and services market is in equilibrium at the full employment level of employment. Government budget is balanced. In case the credit crunch reduces consumption and investment it will mean that the AD curve will shift to the left. The economy will therefore move into a recessionary gap. The government is not changing its spending or taxation policies, so spending stays the same, but taxes will fall. The reason behind this is that taxes are dependent ...

Solution Summary

The expert explains and illustrate graphically with a Keynesian cross diagram. THe government law for balanced income levels are determined.

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