Principles of Macroeconomics
Problem Set #7
Due Wednesday March 26, 2008
Using the IS/LM/FE graphical framework, as well as graphs for the goods, asset, and labor markets,
the short-run and long-run effect of a reduction in the effective tax rate on capital.
There is no change
in the tax rate on labor income.
In each of the four graphs show only three points, an initial general equilibrium
before the tax cut (labeled point A), the short-run equilibrium after the tax cut but before any change in the price
level (labeled point B), and the new long-run general equilibrium (labeled point C).
Based on your graphs and
explanations, fill in the following table using increase (+), decrease (-) or no change (0) beneath each variable to
describe the change in the variable from point A to point C.
Real Interest Rate
Please see the attached figures labeled 1a and 1b.
The shock originates in the goods market and the labor
In the goods market, the cut in the tax rate on capital shifts out the desired investment curve
now want to increase investment since they get to keep more of the proceeds from the investment.
This shifts out
the IS curve to IS’.
There is also a change in the labor market because as the firms use more capital they will also
need more labor (under the assumption that labor and capital are complements).
There is a shift in labor demand
which shifts out the FE curve to FE’.
From this point, the evolution of the economy depends on the relative size of the shifts in IS and FE.
Figure 1a we show a relatively larger shift in IS, while in Figure 1b we show a relatively larger shift in FE.
is silent on the magnitude of the shifts, it just tells us the direction of the shifts.
In Figure 1a, we move to point B in
the IS/LM/FE panel.
Note that this increases output from
The increase in output has repercussions in the
labor, goods and money market.
In the goods market, the increase in income boosts desired savings
the increase in income is not matched one-for-one with an increase in desired consumption
In the money
market, the increase in output increases the demand for money which shifts from
In the labor market, we must be using more workers to produce the higher level of output.
We also know from the
IS/LM/FE panel that point B is off the FE curve, so the labor market must be out of equilibrium.
Thus the demand
for labor must shift even beyond the initial shift due to the increase use of capital.
Thus we are on curve
In the short-run, both wages and prices do not change, so there can be no change in the real
Thus, we must be at a point like B in the labor market, with an excess demand for labor.