Suppose the president calls you in as an economic consultant and tells you that she is worried about the fact that the current government budget is in deficit. She wants to do something to eliminate the deficit but is getting different suggestions from different advisors. She hands you two reports that have been given her, with two policy options and asks you to evaluate them and recommend what she should do.
You go back to your office and check the information that is available to you. You find immediately that government expenditure (G) = 20,000 and taxes (T) are16,000 so you can see that the deficit she is worried about = 4,000.
You then turn to the two policy reports/suggestions.
Proposal #1: The first suggests maintaining current level of government expenditure and increasing taxes until the budget is balanced.
Proposal #2: The second suggests holding taxes constant and reducing the deficit by reducing government expenditures until the budget is balanced.
Your problem is to see what the results of these two different approaches would be and evaluate them. You have available to you a simple economic model, with the parameters calculated, that you can use:Y = C + I + G C = 6,000 + .75Yd (Yd = Y - T)
And you know that:
I = 11,000
G = 20,000
T = 16,000
Once again she asks for suggestions from her policy advisors who give her three different proposals:
1) that she increase government spending on defense by 8,000 (the rationale being that the increase will stimulate the economy and increase the ability of the army to deal with upset citizens at the same time)
2) that she increase unemployment compensation by 8,000 to pacify the unemployed (the rationale being that such welfare payments will act like tax cuts and stimulate the economy) [Note: "unemployment compensation" is what is called a "transfer payment." Although we haven't discussed this in detail, disposable income, which we have been defining as Yd = Y - T includes transfer payments. Because the T here is "net" taxes, i.e., what the government takes minus what it gives, eg. Transfer payments. So T = taxes - transfer payments.]
3) that she increase unemployment payments by 6,000 and reduce taxes by 2,000 (the rationale being that the increase in welfare payments will mollify the unemployed and the tax cut will satisfy tax payer worries.)
And once again, she asks you to evaluate these alternatives. You agree to do so assuming that the full employment level of income is 112,000.