I ONLY NEED HELP WITH THE LAST QUESTION, QUESTIOn e). Thank you. 8. The diagram
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I ONLY NEED HELP WITH THE LAST QUESTION, QUESTIOn e).
Thank you.
8. The diagram below shows an economy which operates with a flexible exchange rate and is initially in short-run equilibrium at point 1, where Y= y and E = El. Now suppose there is a temporary decrease in taxes (&T;). Assume NO changes in any other exogenous variable. a) The effect of this temporary decrease in taxes is to shift the AADD/AA) curve of the economy to the right (right/left) resulting in a(n) increase (increase/decrease) in equilibrium output (Y) and a(n) increase(increase/ decrease) in the equilibrium value of the exchange rate (E) (4 marks) b) Explain why this decrease in taxes causes the equilibrium level of output (Y) to change in the direction you have indicated in answer to part a) Decrease in Taxes will result in an increase in the consumption of the individuals as: (3 marks) C c (Y-T) where C is constant consumption when income is zero As you can see from above equation decrease in taxes results in increase in personal disposable income hence increase in consumption and this increase in consumption results in increase in output. c) Explain why this decrease in taxes causes the equilibrium exchange rate (E) to change in the direction you have indicated in answer to part a) Increase in exchange rate is considered as the appreciation of our currency and our value of currency depends on our exports and imports. Now, as taxes decreases our output hence GDP of a country increasesand as every other thing remains constant, this leads to either decrease in imports or increase in exports and in either case this leads to increase in equilibrium exchange rate. mar d) Between the initial short-run equilibrium (point 1 in the diagram above) and new the short-equilibrium reached after the economy has adjusted to this decrease in taxes, will the amount of the current account balance (CA) of this economy have increased or decreased? Identify and explain the various causes of that change in CA. (3 marks)Explanation / Answer
If the decrease in taxes is a permanent one and is expected to be permanent then both AA curve and DD curve will shift to the right, indicating an increase in the equilibrium level of Y but same E. Because of reduced taxes people would have larger disposable income which in turn will lead to higher consumption and higher demand, leading to the shift of the DD curve. The increase in output when compared to part A will be more. This is because as now the exchage rate is same as before the changes there will no increase/decrease in the imports and exports but the increased output is to cater to the increased domestic demand due to the reduced taxes.
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