4) Congress currently is debating whether to implement a tax cut. Suppose you ar

Question

4) Congress currently is debating whether to implement a tax cut. Suppose you are a policy analyst working for the Congressional Budget Office, and it is your job to analyze the macroeconomic effects of a permanent tax cut. Suppose you have worked out the following very simplified model to characterize basic features of the U.S. economy: Y=4K+5L L-800 G 3000 T 3000 1 = 2000-6000r C- 600+0.6 (Y-T) K-1000 Investment function Consumption function a) First find the equilibrium levels of the interest rate, investment and consumption for the economy described for the equations above. (Use Y-C+I+G, where we assume a closed economy.) Show your work! b) Discuss the effects on the economy of lowering the level ofT by 10%. You should pute the new equilibrium values of the interest rate, consumption and investment. I particular, by how much would investment be crowded out by the tax cut? Again, make sure to show your work. We often think that people are discouraged from buying consumption goods like cars or appliances when interest rates are high. The model above would be more realistic if it took this "interest rate channel" into consideration. Use your economic intuition to predict how this interest rate channel would alter the effects of the tax cut. In particular, would the tax cut crowd out investment more or less than you found in part (b) above? Explain your economic reasoning. Test your guess by trying the following example: C other equations in the before and after the tax cut and compare it with your results of part b c) -600+0.6(Y-T)-3000r, and keep the model as part b. Compute the new equilibrium value of investment d)

Explanation / Answer

Y = 4K + 5 L = 4*1000+5*800

Y = 8000

G = 3000

I = 2000-6000r

T = 3000

C = 600+0.6(Y-T)

a) C = 600+0.6(8000-3000) = 3600

Y = C+I + G

8000=3600+2000-6000r + 3000

6000r = 8600-8000

r = 600/6000

r = 0.1

I = 2000-6000r = 2000-6000*0.1

I = 1400

b ) T = 3000-3000x(10/100) = 2700

C = 600+0.6(8000-2700) = 3780

Y = C + I + G

8000 = 3780+2000-6000r + 3000

6000r = 8780-8000

r = 780/6000

r = 0.13

I = 2000-6000*0.13 = 1220

Investment is crowded out by (1400-1220) 180

c) Due to tax cut there is an increase in consumption by people which is seen from above part b. tax cut reduces the government spending and investment as the income earned by the government reduce so the crowd out will be less.

d ) C = 600+0.6(Y-T)-3000r = 600+0.6(8000-2700)-3000r

C = 3780-3000r

G = 3000

T = 2700

I = 2000-6000r

Y = C+I+G

8000= 3780-3000r+2000-6000r + 3000

9000r = 780

r = 0.087

I = 2000-6000*0.087 = 1478

There is an increase in investment when compared to investment in part b

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