What would be the macroeconomic effect of an increase in government spending financed entirely by an increase in taxes?  

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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The answer to this question depends on the assumptions that you are making.

To a Keynesian, the impact of this action would be to increase GDP without increasing the price level.  This analysis depends on the idea that the aggregate supply curve is flat, which allows aggregate demand to rise without causing inflation.

A more conservative economist, however, would not agree with this analysis.  They would argue, for example, that the impact of the increase in taxes would be to depress the economy.  They would argue that a great increase in taxes would erode the confidence of consumers and business people.  This would reduce both aggregate demand (because consumers would lose confidence) and aggregate supply (because businesses would not invest as much).  This would lead to a decrease in GDP and (depending on the magniude of the declines in AS and AD) potentially to an increase in price levels.

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