Suppose policy makers pass a budget that results in a reduction in government spending and no change in taxes. This reduction in government spending will likely
A) increase government borrowing and increase interest rates.
B) generate extra tax revenues to cover the extra spending.
C) reduce interest rates and increase planned investment.
D) reduce interest rates, increase in planned investment, and increase real GDP.

Question

Quizplus · Accepted Answer

The reduction in government spending will decrease the overall demand for goods and services, causing a decrease in prices and therefore, a decrease in interest rates. With the fall in interest rates, there will be an increase in planned investment, leading to economic growth. Therefore, choice C is the best option. A is not correct because reducing government spending will decrease borrowing, which will decrease interest rates; B is not correct because reducing government spending should lead to a decrease in tax revenues; and D is incorrect because although the reduction in interest rates will increase planned investment, it is not certain that there will be an increase in real GDP.

Suppose Policy Makers Pass a Budget That Results in a Reduction