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Suppose that in the flexible-price full-employment model of this chapter the government increases taxes and government...

Suppose that in the flexible-price full-employment model of this chapter the government increases taxes and government purchases by equal amounts. The tax increase reduces consumption spending. What happens qualitatively (tell the direction of change only) to investment, net exports, the exchange rate, the real interest rate, and potential output?

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Answer #1

Government increases taxes and purchases by equal amounts. It implies that there shall be rise in expenditure or aggregate demand by only one time. Expenditure multiplier is greater than negative tax multiplier. Hence, overall net demand shall rise.

Investment shall rise due to rise in demand.

Net exports would fall due to rise in the import owing to rise in aggregate demand in economy.

Exchange rate is likely to fall due to rise in demand for import.

Inflation will rise, hence real interest rate will most probably fall.

Potential will rise due to increase aggregate demand.

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