Exercise 7 Q I don’t understand the solution to Question 2. A Transfer payments (such as social security and various stipends, subsidies and income support programs) are essentially similar in their macroeconomic effect to tax cuts. Two policy options are put forward in this question: (1) cut public expenditure by the same amount of the transfer (i.e. maintain a balanced budget); (2) borrow money by the same amount of the transfer (the defence minister’s proposal). Option 1 The balanced budget multiplier is 1, and in this case, since we are discussing a cut in public spending, it is -1. In other words, a $1 million spending cut will reduce output and national income by the same amount. AD drops, IS shifts leftwards. In the money market demand for money falls and causes the interest rate to fall too. Prices are unaffected. Private consumption (C) ends up unaffected compared with the initial situation because the transfer payment increases C by MPC*transfer but the subsequent fall in income of the same magnitude reverses and perfectly balances this
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