For each of the following policy changes answer the following question: Does thi

Question

For each of the following policy changes answer the following question: Does this policy change affect growth according to the Solow model (in terms of levels, growth rates or both)? If yes - which variable(s) does it affect? If no, does it affect growth anyway? Why or why not?

a) The government introduces a consumption tax
b) The government sells education bonds and the proceeds are invested in markedly better public

schools

c) A trade agreement is passed which lowers dozens of tarri§s

d) Subsidies to Orms conducting base research are reduced

e) It is annouced that there will be a unprecendented crack-down on corruption at all levels of government

f) The capital gains tax is lowered

g) The central bank increases the money supply

h) The ceiling for maximum contributions to 401(k) accounts is raised

i) A previously enforced one-child-policy is scrapped

j) Weather patterns change leading to much less severe winters which leave roads virtually un- harmed (not a policy change .... or is it...?)

Explanation / Answer

1) The government introduces a consumption tax. It has a significant impact on Solow model. When the government imposes tax, the consumer’s after –tax income will be less than the income before tax. And the marginal return on capital will be less because more cash is needed to fulfill consumption pattern. So savings fall. The taxation leads to downward shift in the, marginal return schedule. As a result, lower savings leads to smaller capital stock and growth ultimately cease.

2) The government sells education bonds and the proceeds are invested in markedly better public schools will not affect the Solow model.

3) A trade agreement is passed which lowers dozens of tariffs will affect the Solow model. This is nothing but the expansionary fiscal policy which affects the economy and the Solow model as well. This decrease in taxation leads to shift of increase of net imports and as a result the AD will shift downwards. As a result the savings will fall and conclude investment also falls. This will lead to fall in growth rate of the capital relative to population

4) Subsidies to an organization conducting base research are reduced will not affect any of the variable in the Solow model. So, it doesn’t affect the growth rate as well.

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