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Econ 303: Bonus Problem Set
Due May 8th, 2018
Equivalent to 5% of the final, but will 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.
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Additionally, he has picked Cain and Moore, who both support low-
ering interest rates, for the current Federal Reserve Board openings. In this question
you will consider the pros and cons of some of these policies through the lens of the
models you have learned this semester.
1. The reduction in taxes changes the incentives for firms to invest and workers
to work.
a. Use the labor supply and labor demand model to show the effects of the
income tax cuts.
b. What happens to the amount of labor in the economy? Explain intuitively
why this occurs.
c. How does this affect output, potential output, and the output gap?
d. The reduction in corporate taxes, raises the after tax MPK, which in
turn increases investment. Use the Solow model framework (no diagrams
necessary), to explain how this will affect output, potential output, and
the output gap in the future.
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It is unclear whether this reversal was caused by the Trump’s pressure or due to changing
circumstances in the economy.
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2. Let us now turn to the short run model, to study the effects of the tax cuts.
a. Assume that Ricardian equivalence does not hold at all, how will the
reduction in income taxes affect consumer spending?
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How does ̄
a
c
and
̄
a
change?
b. Use the IS/MP framework with a constant real interest rate to show the
short run effects of the reduction in income taxes.
c. What will happen to the output gap and inflation?
d. Now add in the drop in corporate taxes leading to more investment de-
mand. What happens to the output gap and inflation?
3. Next we turn to the effects of the President’s efforts to reduce interest rates
on the economy.
a. To keep inflation stable, how should the Federal reserve respond (in terms
of the real interest rate) to the drop in taxes? E.g. in part 2 you have
shown the effects of the tax cuts under a constant interest rate. Now we
allow the Federal Reserve to change it.
b. Show the effects of this response in the IS/MP diagram and on the Phillips
Curve.
c. Now assume, due to executive pressure and new appointments to the
board, the central bank instead cuts the real interest rate. Show the
effects IS/MP diagram and on the Phillips Curve.
d. What is the effect of executive pressure to lower interest rates on the
economy?
4. Finally, let us turn to the long run effects of increasing the deficit.
a. What are the effects of a reduction in taxes without any offsetting gov-
ernment expenditure cuts on future government expenditures and taxes?
b. How will this effect the government’s ability to stabilize the economy in
future recessions?
c. Explain why a higher government deficit might reduce investment.
5. Let us now combine all of the effects together.
a. According to our models, what should be the net effects of the president’s
policies in the short run and in the long run. Summarize and combine
your answers from the previous four parts.
b. Write approximately a paragraph discussing whether you think the Pres-
ident’s policies are good for the economy. There is no right answer as
that will depend on your value judgments of the various costs and bene-
fits, but should be a rational argument. In answering this question, you
may also bring in other things that are not covered by out models (for
example inequality).
1. a) if the taxes are reduced , this would encourage the labours to work more as they will be taxed less, this is income effect. or this would encourage labours to work less and enjoy a bit of luxury , his would be the substitution effect.
b) the overall effect on labour in the economy , depends on the income or substitution effect, if income is stronger the labours will increase and vice versa.
c) the output will increase as due to the cut in taxes , the disposable income has increased , so people will spend more on consumption.
d) if corporate tax is reduced and we look at the solow model framework, firms can invest more in the activities that increases output or in the ones that improves the technology and so you grow. the output gap will reduce in this case
2 a) if ricardian equivalence does not hold , a reduction in taxes would increase the disposable income with te consumers , hence the demand and output.
b) IS shifts to IS'
c) both would increase
d) investments would increase , pushing IS further to the right , output gap and inflation increase.
3 a)
LM will be increased .
4) you are reducing the taxes and still have a high expenditure. i will lead o a pressure being created on the consumers later as they will only have to bare increased taxes in the future . the goverment will lose the confidence of the people and as a reult whaever governmen wants them to do , hey will do the opposite in anticipation of the worse .