The "exit strategy" problem
In fighting the recession associated with the crisis, taxes were cut and government spending was increased. The result was a very large government deficit. To reduce that deficit, taxes must be increased or government spending must be cut. This is the "exit strategy" from the large deficit.
a. How will reducing the deficit in either way affect the equilibrium level of output in the short run?
b. Which will change equilibrium output more: (i) cutting G by $100 billion (ii) raising T by $100 billion?
c. How does your answer to part (b) depend on the value of the marginal propensity to consume?
d. You hear the argument that a reduction in the deficit will increase consumer and business confidence and thus reduce the decline in output that would otherwise occur with deficit reduction. Is this argument valid?