Question

Assume the economy is at full employment as of January 2018 and the government passes a tax bill that reduces taxes by $100B.The tax, however, does not change government spending

What effect is this likely to have on output and prices levels?

What effect will this have on interest rates and investment?

What is the likely response by the Federal Reserve?

Suppose that the economy was below full employment, how would that change your answer?

Answer 1

To answer the below questions we need to understand how the economy works. So total GDP has following elements, Consumption (C), Investment (I), Government Spending (G) and Net Exports (X-M), if any element of the C + I + G + (X - M) formula increases, then GDP or the total demand increases. So if the the “G” portion—government spending at all levels—increases, then GDP increases, keeping all other things constant.

In the case mentioned in question, we need to understand that since the new bill reduces taxes keeping government spending same, it implies that overall G has increased.

Keeping above points in mind, now lets answer each of the question:

1) A tax decrease will increase disposable income, because it leaves households with more money. Disposable income is the main factor driving consumer demand. But it has been mentioned that economy is at a full employment level.

At full employment and the resources are not available for further expansion. It is as if the economy has come up against the wall which prevents it from going any further. The economy, therefore, remains at the full employment level, but, at this level, aggregate demand is greater than output. There is excess demand which cannot be satisfied by an increase in output because there is full employment. Therefore, there is upward pressure on prices and the result is inflation. Hence Output will remain same and price level will increase.

2. First we need to understand meaning of investment from the exonomy's perspective. Investment refers to expenditure on the purchase of physical assets such as plant, machinery and equipment (fixed capital) and stocks (working capital). Such physical or real investment creates new assets — thereby adding to the country’s productive capacity, whereas financial invest­ment only transfers the ownership of existing assets from one person or institution to another.

Now in case of full employment, an increase in G cannot lead to an increase in aggregate demand and output and so C can't be increased. When Investment increases, aggregate demand also increases and, at the end, we observe an increase in employment. But since our economy is already at a full employment level, people instead of investing will save this money and when Savings increase and the money is not getting invested, interest rates will fall.

3. Federal Reserve in order to control inflation will implement contractionary monetary policy to reduce inflation. One popular method of controlling inflation is through a contractionary monetary policy. The goal of a contractionary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates.

4. If economy was below full employment:

(a) Output will increase and price level will remain same.

(b) Investment will increase depending on the Marginal Propensity to Consume, i.e. with increase in net disposable income, some amount of the increase income is consumed and other is invested and ratio of it depends on the MPC.