Question

1. A Supply Shock

Mankiw motivates Question 8 in Chapter 14 of the text as follows: “Some economists believe that taxes have an important effect on the labor supply. They argue that higher taxes cause people to want to work less and that lower taxes cause them to want to work more. Consider how this effect alters the macroeconomic analysis of taxes.”

Here is my version of the question: Suppose taxes are cut. Predict what should happen to income, interest rates, and the price level in the short run and in the long run. This time, however, focus upon the supply-side effects of the tax cuts and ignore the demand-side effects. Assume that the tax cuts are permanent.

Hint: Think about the classical model where labor suppy icreases with the real wage (i.e., the labor supply curve is positevely sloped). The supply- argumented-side argument is that a tax cut would increase labor supply, raising employment, and increasing the natural rate of income (Y). In this question, therefore, interpret a tax cut as causing a permanent increase in the natural rate of income.

Answer 1

Answer:--- when there is lesser taxes, people will hold higher amount of surplus amount with them and it can be used to consumption or investment or savings. any of these three also good to the economy.Tax cut will helps the people to spend higher amounts on purchasing of goods and services. it leads to increase the demand for products, at the same time the supply has to be increased. in short term the supply may not be increased, but in long term it can be increased. In short run the demand for goods will be increase and the prices will be hike. because when the labor supply increases in short run, the wages will comes down. so firms will hire number of labor to produce more units of output.In long run the supply can be modified according to the demand. and if the labor supply is not increased, the cost of labor increases, and so price of the product also increases.
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