# Ps7ans - Economics 202 Principles of Macroeconomics Name_KEY Professor Melick Problem Set#7 Due Wednesday 1 Using the IS/LM/FE graphical framework

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Economics 202 Name: ____KEY_________________ Principles of Macroeconomics Professor Melick Problem Set #7 Due Wednesday March 26, 2008 1. Using the IS/LM/FE graphical framework, as well as graphs for the goods, asset, and labor markets, illustrate and explai n 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 Wage Employment Output Real Interest Rate Consumption Investment Price Level Change + + + ??? + + ??? Please see the attached figures labeled 1a and 1b. The shock originates in the goods market and the labor market. In the goods market, the cut in the tax rate on capital shifts out the desired investment curve d I as firms 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. In Figure 1a we show a relatively larger shift in IS, while in Figure 1b we show a relatively larger shift in FE. Theory 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 to . The increase in output has repercussions in the labor, goods and money market. In the goods market, the increase in income boosts desired savings 1 Y 2 Y ( ) d S because the increase in income is not matched one-for-one with an increase in desired consumption ( ) d C . In the money market, the increase in output increases the demand for money which shifts from ( ) 1 , e LYr π + to ( ) e r Y L + , 2 . 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 () 2 1 Y ND N α =− ⋅ . In the short-run, both wages and prices do not change, so there can be no change in the real wage. Thus, we must be at a point like B in the labor market, with an excess demand for labor.

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## This note was uploaded on 05/13/2010 for the course ECON 323 taught by Professor Jakes during the Spring '10 term at Alcorn State.

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Ps7ans - Economics 202 Principles of Macroeconomics Name_KEY Professor Melick Problem Set#7 Due Wednesday 1 Using the IS/LM/FE graphical framework

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