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In the classical model, what is the effect of an increase in government spending that is...

In the classical model, what is the effect of an increase in government spending that is not financed by an increase in taxes (an increase in the deficit)? How do prices, real GDP, consumption, saving, investment spending, and real interest rates change as a result of the increase in government spending? Explain and show graphically.

(Hint: Use the market for loanable funds model.)

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Answer #1

Increase in government spending increases aggregate demand . This shifts AD rightwards to AD'. This leads to increase in price from P1 to P2 and real gdp remains same at Y. Consumption remains the same real GDP is constant.

Due to increase in price real money balances fall which leads to decrease in supply of loanable funds. This shifts S leftwards to S'. This results in lower investment and higher interest rate. Savings also fall because higher price is charged now.

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