Question

1. Suppose an economy is Initially in equilibrium at potential GDP, Y*. Then the government decreases the net tax rate (t).

1. Briefly explain in words (1-2 sentences without a diagram) What type of gap would be caused by this policy AND the impact on real GDP and the price level in the short-run.

Decreased net tax rate cause an overall decrease in real GDP,

2. Briefly explain in words (1-2 sentences with no diagram) how the economy adjusts back to the long run equilibrium if left alone and no further fiscal or monetary policy is used.

3. In going from the short run equilibrium to the long-run equilibrium, briefly explain (1 sentence) how the composition of real GDP may have changed.

4. Briefly explain what the difference in the growth rate of potential GDP might occur If instead of a decrease in the net tax rate, there was an increase in government purchases (1 sentence).

5. Briefly explain (1-2 sentences without a diagram) what the “Money Neutrality” argument implies about the effectiveness of discretionary fiscal policy and the impact on potential real GDP and price level in the long run.

Answer 1

a) With decrease in the net tax rates, the profit margins of the firms are expected to increase as the taxation cost would be reduced and hence it is expected to cause an increase in the production of firms which in turn is expected to cause an increase in the real GDP in the short run. With more production, it would mean that the price levels are expected to fall in the short run.

b) In the given case, the tax rates are decreased which would mean that there is an increase in the production and GDP in the short run. This would cause a rise in the inflation and hence would result in lower wages for the employees and this can result in lowering the production and readjustment of the economy in the long-run

c) In the given case, the personal consumption would decrease, business investments would decrease and the production is also expected to decrease and reach an equilibrium while moving from short-run to long run.

d) An increase government purchase would mean an increased spending in the economy and this would cause an increase in the GDP as the production would increase in the short run and in moving from short-run to long-run, as a result of inflationary effects, the production is expected to decrease.

e) The Money Neutrality argument suggests that the change in the stock of money would only cause a change in the nominal variables in the economy such as wages, prices, exchange rates etc and would have no impact on the real variables like employment, real GDP and real consumption. Thus, a fiscal policy could result in an adjustment in the price levels in the long run, but would have no impact on the potential GDP according to the Money Neutrality argument.