Q1)

Note: If a government maintains a balanced budget, this implies that total government expenditure is financed from government taxes . Hence if = , there is no government budget deficit or surplus.

a)Assume that Autaria has a law that requires its government to maintain a balanced budget at all times. Does this law imply that Autaria's government can no longer use a temporary increase in government spending to increase aggregate output in the short-run? What is the effect of a permanent increase in government spending on aggregate output in the shortrun? Explain with the help of a figure.(2.5 marks)

b)Assume that Autaria's government has a balanced budget initially but there is no law that requires the government to maintain a balanced budget at all times. Assume further that the government cuts taxes temporarily. This leaves Autaria's government with a government budget deficit ( > or > 0), that it must somehow finance. Suppose people think that the government will finance its deficit by printing extra money. What is the overall effect of the above on aggregate output in the short-run? Does the domestic currency appreciate or depreciate against the foreign currency in the short-run? How does this compare with a hypothetical case where there is a temporary decrease in taxes, keeping all other variables constant? Explain with the help of a figure.