Question

Explain what happens to the output gap, unemployment, and inflation in the short run if there is a permanent income tax cut implemented by the federal government. You do not need to draw any graphs, but thinking about the short run model will help. Be sure to explain which part of IS/MP/PC is affected and why. You may start with an economy at full employment and inflation at the central bank target. Also, discuss what the central bank is likely to do in response to this event.  

Answer 1

In an economy with full employment and inflation at central bank target if the income tax rates are permanently cut down or we can say 0% by federal government it will leads to have effect on unemployment, output gap and inflation. Output gap is the difference between the expected and actual output.

If tax rate become 0%,real income of person increases. Now if a person who is getting $85 after tax of 15% on $100.,he will get full $100. As a result of which demand is increased, it will leads to increase in inflation above the target rate of central bank, also output gap increases because people will now able to invest full $100 rather than $85.and hence unemployment will decrease beyond full level of employment. As if you consider that there is already full employment then too be there is reduction in unemployment as due to tax rate cut, other migrants workers from other countries are also attracted. So such a gap is fulfilled there.

IS (income spending) , MP (monetary policy which is used by central bank in order to maintain stability in economy), PC (Phillips curve). Due to tax rate spending of individuals may be increased in short run, so investment, their consumption or exports are effected in case of IC. In case of MP, commercial borrowing is very much effected. Earlier people have less money so they borrowed money from banks, so it becomes difficult for banks as Main function of bank is accepting deposit and lending money. In case of PC, both the unemployment and inflation is effected in short-run. PC shows there is inverse relationship between unemployment and inflation in short-run not applicable in long run.

Now in order to tackle the problem of inflation above the target rate central bank may use interest rate higher ,or the best way is to issue securities in market and control the excess flow of money. Central bank will control on inflation as it ultimately effect the unemployment or on output. Hence, we can say that there are positive effect in short-run but if this is untreated it may leads to have negative effects on the economy. Like - out of control of money, scarcity of resources due to overpopulation, etc.