b) (20
POINTS) Now we are going to focus on the idea that in the longer run, the influence of the decrease in the effective tax rate
on capital will have ‘supply-side’
effects. In particular, we argue that
this new investment, spurred on by the lower effective tax rate on capital,
will result in a positive productivity shock resulting in a higher “A and K”
which will result in a shift upward in the production function (via increasing the
MPKf and MPN….these are the supply side effects) In the space below
draw a production function with the labor market diagram directly below it and
show what is going on in this longer run. That is, locate the corresponding
point B (from above), and then show the longer run influence as point C in
these two (supply – side) diagrams. What
happens to N* and w*=W/P? Explain in
detail. Are these results in the labor market consistent with sub-title of
the article and the business cycle facts?
Now explain why output has changed, give two specific reasons. Note, in this part of the problem, do not
worry about identifying point A in the labor market diagram and production
function diagram since point A does not exist given the assumption that labor
markets always clear at full employment (i.e., a weakness of the classical
model). Be sure to label your graphs completely
(relevant shift variables) or points will be taken off.
Now show how graphs 1) through 4) are
influenced by this longer-run development.
Note again that we assume that before these longer run developments take
hold, the FE line in graph 3) and the LRAS in graph 4) is set at YB.
Now let these longer run developments take hold, i.e., these supply side
effects, and label this final equilibrium as point C. Again, please make sure
you refer to each diagram
individually explaining
how and why we get to point C (i.e., provide intuitive economic
reasoning!). Be sure to include a
discussion of why the real interest rate has to change the way it does – hint,
the money market!
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