Question

In: Economics

Suppose an economy is Initially in equilibrium at potential GDP, Y*. Then the government decreases the...

Suppose an economy is Initially in equilibrium at potential GDP, Y*. Then the government decreases the net tax​ rate (t).

  1. Briefly explain in words (1-2 sentences without a diagram) What type of gap would be caused by this policy AND the impact​ on real GDP and the price level in the short-run.

  2. Briefly explain in words (1-2 sentences with no diagram) how the economy adjusts back to the long​ run equilibrium if left alone and no further fiscal or monetary policy is used.

  3. In going from the short run equilibrium to the long-run equilibrium, briefly explain (1 sentence) how the composition of real GDP may have changed.

  4. Briefly explain what the difference in the growth rate of potential GDP might occur If instead of a decrease in the net tax​ rate, there was an increase in government purchases (1 sentence).

  5. Briefly explain (1-2 sentences without a diagram) what the “Money Neutrality” argument implies about the effectiveness of discretionary fiscal policy and the impact on potential real GDP and price level in the long run.

Solutions

Expert Solution

a) A reduction in net tax rate will lead to an upward shift in aggregate demand curve and the intersection of new aggregate demand curve with Short run aggregate supply curve will lead to a rise in real GDP and price level which implies the existence of an inflationary gap.

b) With out monetary policy and fiscal policy the economy corrects itself via the supply shock caused by the higher wages and higher prices of factors of production.

c) Since Fiscal policy isn't used government expenditure component would have remained unchanged where as consumption, investment and net exports must have been experienced a fall caused by unemployment and lower production.

d) As a far as an increase in government expenditure is concerned,it might lead to a lesser growth in potential GDP and price level due its negative impacts like crowding out and higher debt obligations..

e) Money being neutral implies that, it won't be able to influence real variables like output and monetary policy Will be ineffective. In such a situation, discretionary fiscal policy is highly effective as concerned with demand rather than stock of money.


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