Question

Econ 103: Bonus Problem Set

Due May 8th, 2018

Equivalent to 12% on a midterm, but does not affect the curve so

this is truly optional.

Trump has consistently pursued policies aimed at stimulating the economy. On

the regulatory side, his administration has worked to reduce regulation on corpo-

rations and banks. On the fiscal side, the president supported and signed the tax

cut act of 2017 reducing personal and corporate income taxes (among other things).

And on the monetary policy side, he has actively criticized the central bank’s ”tight”

monetary policy approach and called on the Federal reverse to reverse course, which

it did in 2019.

It is unclear whether this reversal was caused by the Trump’s pressure or due to changing

circumstances in the economy.

2. Let us now turn to the short run model, to study the effects of the tax cuts.

Use the AD/AS model and the Phillips Curve to answer these questions.

a. How will the reduction in income taxes affect consumer spending?

b. Use the AS/AD model to show the short run effects of the reduction in

income taxes.

c. What will happen to the output gap and inflation in the short run?

d. What will happen to the output gap and inflation in the long run?

e. Now add in the drop in corporate taxes leading to more investment demand. What happens to the output gap and inflation?

Answer 1

2.a) A reduction in income taxes increases the spending power of the consumers. The lower rate of taxes leaves more money in the hands of the consumer , thus increasing their purchasing power.

b) Since the workers are better off with a lower tax rate their spending increases. This will shift the Aggregate Demand (AD ) to the right. The economic growth increases because the consumer spending is a component of AD.

The shift in AD is possible only if the tax cuts are financed by the government borrowing. The government is injecting unused resources to the circular flow. But if the tax cuts are financed by spending cuts AD will not increase because some people are better off from the tax cut, but others will cut their spending due to a decrease in welfare payments .

c) The difference between the actual output and the potential output of an economy is known as output gap. It can be positive or negative.

When the consumer spending increases there is a high demand for goods and services in the economy and this creates a positive output gap.

This means the real GDP exceeds the potential GDP. The prices are pushed up causing inflationary gap

d) In the long run the government use fiscal policies to close the output and inflationary gap. When there is a positive output gap the government adopts contractionary or tight fiscal policy to reduce the demand and combat inflation through lower spending.

e) When the corporate taxes are reduced along with a reduction in income tax it will have a multiplier effect on the output and inflationary gap . This is because a decrease in corporate taxes will also boost the production process in the economy.