In 2010, the British government proposed reducing the British budget deficit by increasing net taxes and reducing government spending. Some economists claimed that this combination of fiscal policies would reduce interest rates and increase real GDP, as well as cut the deficit.
a. Draw an IS/LM graph to analyze the effects of this combination of fiscal policies on real GDP, the real interest rate, and the budget deficit. (Assume that taxes are lump sum, that is, assume taxes are an absolute amount that is unrelated to the level of income.) Which of the economists' three predictions (about real GDP, the real interest rate, and the budget deficit) are inconsistent with our model?
b. Most economists who believed that an increase in taxes and a reduction in government spending would increase GDP and cut the budget deficit implicitly assumed that the Bank of England (the British central bank) would change its monetary policy if the deficit-reduction plan in part a. were enacted. Draw another IS-LM graph to show what kind of monetary policy must accompany this combination of fiscal policy changes in order to decrease the budget deficit and interest rates, while increasing GDP.
