) Note: i) Y is real domestic output; ii) E is the exchange rate in domestic currency/foreign
currency terms, iii) if a government maintains a balanced budget, this implies that total government
expenditure G is financed from government taxes T. G T implies there is a government budget
deficit.
For parts a) b) c) and d), assume
i) Investment I is fixed.
ii) The government only purchases domestic products.
iii) Aggregate consumption C is composed of domestic and foreign products.
iv) Households’ marginal propensity to consume out of disposable income is less than one.
In addition, assume, for parts a) and b) that a country X has a law that requires its government to
maintain a balanced budget (G = T) at all times.
a) Does this law imply that X can no longer use a temporary increase in government spending
to increase aggregate output in the short-run? (2.5 marks)
b) What is the effect of a permanent increase in government spending on aggregate output in
the short-run (for country X)? Explain with the help of a figure. (2.5 marks)
For parts c) and d), assume that there is no law that requires the government to always maintain a
balanced budget. Assume further that the government cuts taxes temporarily which leads to a
budget deficit.
c) What is the overall effect on Y and E in the short-run if people expect the government to
finance its budget deficit by printing extra money in the future? Explain with the help of a
figure. Note: printing extra money can be understood as a permanent monetary expansion.
(3 marks)
d) Relative to part c), compare the effect on Y and E in the short-run if there is only a
temporary decrease in taxes without the expectation that the government will monetize the
debt in the future? Note: assume that the budget deficit is financed through some initial
government wealth. (2 marks)

Question

) Note: i) Y is real domestic output; ii) E is the exchange rate in domestic currency/foreign 
currency terms, iii) if a government maintains a balanced budget, this implies that total government 
expenditure G is financed from government taxes T. G > T implies there is a government budget 
deficit. 
For parts a) b) c) and d), assume 
i) Investment I is fixed.
ii) The government only purchases domestic products.
iii) Aggregate consumption C is composed of domestic and foreign products.
iv) Households’ marginal propensity to consume out of disposable income is less than one.
In addition, assume, for parts a) and b) that a country X has a law that requires its government to
maintain a balanced budget (G = T) at all times.
a) Does this law imply that X can no longer use a temporary increase in government spending 
to increase aggregate output in the short-run? (2.5 marks)
b) What is the effect of a permanent increase in government spending on aggregate output in 
the short-run (for country X)? Explain with the help of a figure. (2.5 marks)
For parts c) and d), assume that there is no law that requires the government to always maintain a 
balanced budget. Assume further that the government cuts taxes temporarily which leads to a 
budget deficit.
c) What is the overall effect on Y and E in the short-run if people expect the government to
finance its budget deficit by printing extra money in the future? Explain with the help of a 
figure. Note: printing extra money can be understood as a permanent monetary expansion. 
 (3 marks)
d) Relative to part c), compare the effect on Y and E in the short-run if there is only a 
temporary decrease in taxes without the expectation that the government will monetize the 
debt in the future? Note: assume that the budget deficit is financed through some initial 
government wealth. (2 marks)

Accepted Answer

∻a Solution∻ ‖ a ⋮ Balanced Budget Multiplier: The balanced budget multiplier suggests that an increase in government spending financed by an equal increase in taxes will still increase aggregate output. This is because the marginal propensity to consume (MPC) is less than one, so the full amount of taxes is not withdrawn from consumption. ‖ ∻a Answer∻ ⚹ No, the law does not imply that X can no longer use a temporary increase in government spending to increase aggregate output in the short-run. ⚹ ∻Key Concept∻ ⚹ Balanced Budget Multiplier ⚹ ∻Explanation∻ ⚹ A temporary increase in government spending, even with a balanced budget, can still increase aggregate output due to the multiplier effect. ⚹ ∻b Solution∻ ‖ b ⋮ Permanent Increase in G: A permanent increase in government spending with a balanced budget means taxes are also permanently increased. This would lead to a higher level of aggregate demand (AD) due to the multiplier effect, as government spending has a direct impact on AD, while the tax increase has a less than proportional effect due to the MPC being less than one. ‖ ∻b Answer∻ ⚹ A permanent increase in government spending will increase aggregate output in the short-run for country X. ⚹ ∻Key Concept∻ ⚹ Permanent Government Spending Increase ⚹ ∻Explanation∻ ⚹ The increase in aggregate demand from higher government spending outweighs the decrease from higher taxes, leading to a net increase in aggregate output. ⚹ ∻c Solution∻ ‖ c ⋮ Monetary Financing of Deficit: If people expect the government to finance its budget deficit by printing extra money, this will lead to expectations of inflation. The increase in money supply reduces interest rates in the short run, leading to higher investment and consumption. However, the expectation of inflation can lead to a depreciation of the domestic currency (E increases), making imports more expensive and exports cheaper. ‖ ∻c Answer∻ ⚹ The overall effect on Y is an increase, and E will increase (domestic currency depreciates) in the short-run. ⚹ ∻Key Concept∻ ⚹ Expectations of Inflation ⚹ ∻Explanation∻ ⚹ The anticipation of future money printing can lead to higher aggregate output due to lower interest rates and a weaker domestic currency due to inflation expectations. ⚹ ∻d Solution∻ ‖ d ⋮ Temporary Tax Cut: A temporary tax cut without the expectation of future money printing will lead to an increase in disposable income and thus consumption. However, since the tax cut is temporary and not expected to be monetized, the effect on aggregate output Y is smaller compared to when money printing is expected. The exchange rate E may not change significantly if the temporary tax cut does not alter expectations about long-term inflation or currency value. ‖ ∻d Answer∻ ⚹ The effect on Y is an increase, but smaller than in part c), and the effect on E is less pronounced. ⚹ ∻Key Concept∻ ⚹ Temporary Tax Cut ⚹ ∻Explanation∻ ⚹ A temporary tax cut boosts consumption and aggregate output, but without expectations of monetizing the debt, the impact on the exchange rate is less significant◊What is the impact of a permanent increase in government spending on aggregate output in the short run?⍭ Generate me a similar question◊⚹

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