Question

2. Suppose the government is considering a tax policy that will reduce taxes by $100. In the economy, households consume 80% of each additional dollar earned. Assume that the tax cut has no effect on GDP(Y).

(a) How will this tax cut affect consumption?

(b) Calculate the change in private savings.

(c) Calculate the change in government savings and national savings.

(d) What will happen to the current account as a result of this policy?

(e) How would your previous answers change if we assume Ricardian equivalence? (Note: The The- ory of Ricardian Equivalence is described in textbook section 5.2’s Application “Global Imbalances”.)

Answer 1

Given that,

Consider the government take a tax policy

reducing the tax =$100

house hold consume =80%

A) Cut affect consumption:

the given house hold consumption=80% or 0.08

MPC = 0.80

The consumption will increase by MPC * tax = .80* 100 = $ 80

B) Change in private saving:

Since out of $100 increase in disposable income due to decline in taxes, $80 is spent on consumption.

Thus, the remaining $20 will be saved.

There fore, the private savings will increase by $20.

C) Government savings and national savings:

already given that

The government savings will decline by $100.

Net effect on national savings= -$100 + $20 = -$80

So, national savings will decline by $80.

d. Current Account = Savings - Investment

The decline in the national savings will lead to the decline in the current account balance.