Problem:
Suppose that initially the goods and services market is in equilibrium at the potential (full-employment level) of output and that the government budget is balanced, that, is government spending equals tax revenues.
1) Now suppose that because of headwinds from a credit crunch, consumption and investment fall. Also suppose that the government does not change its spending or taxation policies. What will be the effect on the budget gap, that is, on the difference between government spending and tax revenues? Explain.
2) Suppose that the government has a law that the budget must be balanced at every level of income. How must it respond to the credit crunch? Is this a good law? Explain and illustrate graphically with a Keynesian cross diagram.