Question from Past Macroeconomics Qualifying Exam (Fall, 2003 - Question four) at George Mason University[]

The current Republican Administration in the United States has shifted the federal budget sharply from surplus into deficit. Discuss the predictable impact of this shift on interest rates, exchange rates, trade balance and aggregate output in the United States, utilizing the following models:

  • a. A traditional Keynesian model;
  • b. A Neo-Keynesian model with real rigidities;
  • c. A rational expectations model;
  • d. Do you consider the policy of the current administration with respect to federal

budget deficits to be healthy for the U.S. economy. Define "healthy".


  • (a) The increase in government spending will shift the IS curve outward along the LM curve (assuming a positive slope) and this will increase interest rates while increasing the aggregate output of the economy. Adding Mundell-Flemming open market analysis, the increase interest rate would create capital inflows (assuming somewhat high capital mobility and that the country is not large enough to SET the interst rate, merely affect it), this would make output more expensive for foreigners while making imports cheaper for domestic holders of the dollar. This change in the trade deficit would create a contraction at least as far as the new equilibrium interest rate.
  • (b) The increase in consumption int the model will not effect the price level (including the interest rate) Output will suffer and the economy will contract. The price level will eventually drop, but not in the short-term.
  • (c) A rational expectations model would predict that people will see through this temporary solution and save additional ammounts to compensate for the increased tax bills sure to come in the future. If not individuals doing this to protect themselves, the representative agent, through the financial markets will act this way.
  • (d) The federal government could pursue a "healthy" (= efficient) outcome by reducing the role they play in the economy. If we were to assume that the high level of debt accumluation would encourage the administrators to lower the budget and reduce the size of government in the economy this could be a "healthy" solution.

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