Suppose the government wants to reduce its budget deficit. Using the long-run model of the economy developed in Chapter 3, illustrate graphically the impact of the alternative fiscal policy measures indicated in parts (a) and (b) below (one graph for each part). Be sure to label: (i) the axes; (ii)

the curves; (iii) the initial equilibrium values; (iv) the direction curves shift; and (v) the final equilibrium values.

a) Suppose the government decides to reduce the government's budget deficit by reducing government expenditures. What happens to: (i) national saving; (ii) the real interest rate; (iii) investment; (iv) consumption; and (v) output? Explain in words why these variables change or why they do not change. Illustrate graphically.

b) Suppose the government decides to reduce both government expenditures and taxes by the same amount (this is a "balanced budget" change). What happens to: (i) national saving; (ii) the real interest rate; (iii) investment; (iv) consumption; and (v) output? Illustrate graphically and explain in words why these variables change or why they do not change.