You are given the following information about the economy in 2010 (all in billions of dollars): Consumption function: C = 100 + (.8 *Yd) Taxes: T = -150 + (.25*Y) Investment function: I = 60 Disposable income: Yd = Y - T Government spending: G = 80 Equilibrium: Y = C + I + G

Hint: Deficit is D = G - T = G - [-150 + (.25*Y)].

a. Find equilibrium income. Show that the government budget deficit (the difference between government spending and tax revenues) is $5 billion.

b. Congress passes the Foghorn-Leghorn (F-L) amendment, which requires that the deficit be zero this year. If the budget adopted by Congress has a deficit that is larger than zero, the deficit target must be met by cutting spending. Suppose spending is cut by $5 billion (to $75 billion).What is the new value for equilibrium GDP?

What is the new deficit? Explain carefully why the deficit is not zero. c. Suppose the F-L amendment was not in effect and planned investment falls to I = 55.What is the new value of GDP?

What is the new government budget deficit? What happens to GDP if the F-L amendment is in effect and spending is cut to reach the deficit target? (Hint: Spending must be cut by $21.666 billion to balance the budget.)