Consider a situation where, pressured by a conservative Congress to balance the budget, the government reduces public expenditure with no change in taxes.
a) What would be the effects of this policy (the decrease in government spending) on equilibrium output in the goods market? Explain how and why equilibrium output would be affected. Illustrate your answer in the appropriate diagram.
b) Discuss the effects of the decrease in government spending on equilibrium levels of output and interest rate in the economy using the ISLM model. Explain which market (or markets) is (or are) affected and which curve (or curves) shifts (or shift). Illustrate your answer with the appropriate diagram(s).
c) Given the effects derived in part (b) above, what would be the ultimate effect of the policy on investment? Explain.