Chapte2r_on_Static_GE_Model - Chapter 2 Static General...

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1 Chapter 2 Static General Equilibrium Models Chapter Overview The main purpose of this chapter is to familiarize students with some of the main tools used by economists since the transformation of macroeconomics. In particular, the chapter will demonstrate the use of microeconomic theory in macroeconomics. Additionally, it will demonstrate the principle of general equilibrium analysis. Lastly, it will demonstrate the calibration methodology. Microeconomic theory is simply consumer and producer theory, from which we will derive consumers’ demands for final goods, households' supplies of productive factor inputs, producers’ supplies of final goods, and producers’ demands for inputs. General Equilibrium simply combines these demands and supplies to simultaneously find the market clearing prices and quantities. In the calibration procedure, we show how to use a model to evaluate government policy that impacts the labor supplies of individuals. The one component of post-transformation macroeconomics that is not covered in this section is dynamics. The discussion and analysis in this chapter will center on a static model, where the decisions made by the economy’s actors have no affect on their future decisions. The main decision that the chapter will study is the labor-leisure decisions of households and the hiring decision of firms. In truly dynamic models, decisions are intertemporal, namely decisions that are made today are known by the decision maker to affect his future situation, are not considered in this chapter. An example of an intertemporal decision is how much income a household should save.
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2 Another example is how much investment a firm should undertake. These and other dynamic decisions will be addressed later in the book. Despite the absence of dynamics, the model we develop in this section is a useful device for drawing scientific inferences, and it lays the foundation for much of what we shall do in the remainder of the book. There are a number of questions that we can address with it. One question is whether differences in tax rates on labor income across countries can account for the observed differences in hours worked per person in these countries. Another question, and one you will be asked to answer, is what is the tax rate on labor income that would maximize the government’s tax revenue? This question is one that is particularly relevant to policy makers. Indeed, it was at the heart of the political debate in the late 1970s, which brought Ronald Regan to the White House. One of the promises that Ronald Regan made was to lower the marginal tax rate on people’s labor income and increase the federal government’s tax revenues. The principal idea behind this policy is known as the Laffer Curve , named after Arthur Laffer, (who purportedly introduced the idea on a napkin at a cocktail party). The Laffer Curve shows the amount of government revenues that are generated for tax rates between 0 and 100 percent.
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