Question

You are an economic advisor in a developing country with a fixed exchange rate. While your country has an open capital account, your financial markets remain imperfectly integrated with those of the rest of the world. The central bank in your country targets the stock of domestic credit. One day, an IMF team arrives and convinces the Finance Minister that your country’s fiscal deficit is excessive. The Finance Minister persuades the parliament to pass a tax increase to reduce the deficit. Explain what effect you would expect this measure to have on:

a. The aggregate price level and level of real GDP.

b. The level of employment and the real wage

c. The level of exports, of imports, and of net exports

Answer 1

a. In order to finance the budget deficit, a tax increase is introduced. An increase in tax rates would reduce the consumption and investment in the economy. This can have multifold effect on real GDP. The GDP would reduce due to increase in tax rate. At the same time, since there is a reduced demand in the market, prices would fall. The net effect on real GDP depends upon the level of fall in GDP and the fall in prices but generally the fall in GDP is higher than the fall in prices, hence the real GDP woud be expected to fall.

b. Due to the increase in tax, there can be two type of effects on level of employment. Since the increase in tax would reduce the net income with the labour, they might start working more due to income effect and labour supply increase, leading to fall in both wages. Since the prices reduce as explained in part a, impact on real wages is ambiguous. However, there is another effect at play. Due to the increase in tax rates, and lower income, the labour might find himself with lesser income with as they put in more effort and substituion effect turn out to be stronger, so they reduce the labour hours leadin to increase in wages and increase in real wages as prices also fall.

c. Since domestic consumption will reduce, exports can increase. Imports will increase as income reduces due to fall in taxes. Hence, net exports will fall. This will also depend upon the types of taxes. If there is sales tax, then imports may seem cheaper and increase. In this impact on next exports is ambiguous.