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Chapter 21: Problem 9

In problem 2.8 , suppose that government purchases increase from \(\$ 2\) trillion to \(\$ 2.5\) trillion. If the values for \(Y\) and \(C\) are unchanged, what must happen to the values of \(S\) and I? Briefly explain.

Short Answer

Expert verified
The sum of S and I has to decrease as G is increasing to maintain the national income identity equality. The economy must decrease savings and/or investment to finance the increased government purchases.

Step by step solution

01

Understanding the national income identity

The basic national income identity equation is \( Y = C + I + G \) where Y is the national income, C is total consumption, I is investment and G refers to government purchases.
02

Given values in the equation

From the problem, it is clear that Y and C are unchanged but G increases to \$2.5 trillion. Substitute these known values into the equation.
03

Determine changes in S and I

Since Y=C+I+G, and Y and C are constant while G is increasing, the sum of I and S has to decrease by the same amount that G has increased in order to maintain the equality because Y = C + S + T, where T are taxes which are equal to G in the given case. In other words, the increase in G has to be offset by a decrease in I and S in exactly the same amount. As both S and I are sources of financing for the economy’s investment in new capital, the economy must decrease S and/or I to finance the increase in G.

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