2 Suppose Congress increases G to fix public infrastructure

2. Suppose Congress increases G to fix public infrastructure. Being fiscally responsible, they do so in a balanced-budget way so that T is increased by the same amount as G a. What will happen to investment (I) and the real interest rate (r) b. How does your answer depend on the MPC. Explain

Solution

a)

Since here both expenditure and tax rise in same proportion. Here, government will not resort to public borrowing. There would not be crowding out effect. thus, no rise in interest rate.

Further, if both government expenditure and tax rise in proportion, then value of multiplier would be 1. thus, investment increases equal to G.

Real interest rate shall fall if there is rise in inflation rate due to rise in government spending.

b)

Value of multiplier depends on the MPC but here both tax and expenditure rise simultanesouly in same proportion. Hence, MPC will not affect value of multiplier here.