Question

For each of the following statements determine if the statement is TRUE, FALSE, or UNCERTAIN. You must justify your answer graphically. No credit will be given without an explanation.

(a) “According to the large-open economy model, if Japan (a large open economy) were to decrease its taxes it would cause both the real interest rate and net exports to increase.” [Hint: In your answer you will need to draw three diagrams]

(b) “In the Solow Model with no technological progress, the steady-state level of capital per worker (k*) will decrease if the depreciation rate decreases.”

Answer 1

a. The given statement is true. If a large economy were to decrease its taxes, it would cause both real interest rate and net export to increase. A decrease in taxes causes increase in labor supply due to increase in after tax wage. Increase in labor supply increase the production of good and services. It will increase the supply of good and services causes aggregate supply curve to shift right. It leads to fall in price level in domestic economy. Decrease in tax rate increases both investment and saving rate. Which causes real interest rate to fall.

A fall in price level in domestic economy makes exports of domestic economy cheaper to foreigners. It causes exports to rise and imports to fall. It results net exports to rise.

b. The given statement is false.In the Solow model with no technological progress, the steady -state level of capital per worker will increases, if the depreciation rate decreases. An decrease in depreciation leads to increase in capital per worker and output. An increase in depreciation leads to decrease in capital per worker and output