Question

If a tax cut does not impact the economy’s ability to produce, it will nonetheless tend to have some

effects. Present an analysis of how a tax cut will impact the economy using the tools presented in

class (i.e., a labor market, the IS-LM framework, and an AS-AD diagram) and the Classical

perspective. In particular, predict the impacts on employment, the nominal wage level, the real

wage level, the output level, the price level, and the real interest rate level.

Answer 1

A tax cut will have strong effect on disposable income which is now higher. This implies that both consumption and (private) savings are increased. National savings will because public saving will fall more than rise in private saving. This encouragement to consumption and investment (reduction in corporate tax) will shift AD to the right.

Short run implications

Real wage falls as price level rises. Interest rate is increased as National savings fall. Unemployment is reduced and nominal wages are sticky.

Long run

Real wages rise and return to pretax level as nominal wages are increased Firms hire less labor so unemployment is increased. Output level is reduced and returns to full employment level and real interest rate also reaches its pretax level.