Question

Suppose any environmental degradation arising from the US consumption of energy was subject to a Pigovian tax (a tax on consumption where the tax paid fully covered the environmental damage). For the purposes of a macroeconomic model, you may assume a Pigovian tax on consumption will reduce consumption, so you can model it as an autonomous decline in consumption. Starting from an initial macroeconomic equilibrium at full employment output, trace out the short run and long run adjustment to this tax. Be sure to include the national income identity with long run effects beneath.

Answer 1

the diagram above represent AD-AS macreconomic model of the pigviaon tax imposed on the economy . AD is aggregate demand curve , SRAS is short run aggregate supply curve and LRAS is long run aggregate supply curve at Y* ( natural level of employment) . initially equlibirium is at E with price P1. when the tax is charged due environmental degradation then it reduces the consumption which shifts the aggregate demand curve from AD to AD' so short run equlibirium is E2 which shift economy equlibirium level of employment to Y2. so introduction of tax will also decrease relative income in the economy and so as unemployment rate will increase . now when the producers will come to know about the decrease in the price level then they will shift the SRAS to SRAS' i.e. downwards . new equlibirium is at E3. E3 is at potential level with full employment but less consumption and less price level P3 .