Consider a closed economy in the long run.

C = 150 + 0.6 (Y-T)

I = 300 - 10r

G = 500

T = 250

And a natural rate of output of 1,750.

a) Show savings and investment on a well labelled diagram with the real interest rate on the vertical axis.What happens to savings when the government deficit increases?You should solve for savings and label it correctly on your diagram.

b) Solve for the equilibrium real interest rate, r.What share of expenditure goes to consumption, investment and government purchases? What is the debt to GDP ratio?

c) Suppose that the government would like to balance its budget.

i) Increasing taxes.

ii) Decreasing government spending.

Discuss the effects on consumption and investment of balancing the budget in both cases.What role does the real interest rate play?You do not need to calculate the values, just use reasoning and your graphs to discuss.

d) Discuss why balancing the budget had no effect on real GDP.Does this mean that changes in taxes and government spending can never have an impact on real GDP?