Question 1
a)
In the short run
In order to illustrate the effect of the economic policy for US economy in the short run, IS-LM model will be used. The first step, which should be taken in order to answer the question, is identifying which economic policy is used in order to reduce US government deficit. The policy used in this case is contractionary fiscal policy. This is known because it states in the question that the taxes were increased and government expenditure did not change. The second step will be explaining the effect of contractionary fiscal policy on US economy. Below GRAPH 1 illustrates this particular case in the short run ↓.
GRAPH 1
IS curve shown in the graph represents the equilibrium in the goods market, before the increase in income tax. LM curve represents equilibrium in financial market before the increased income tax. The intersection between IS and LM curves, marked A, is the initial equilibrium between goods and financial markets. When the income tax is increased, the IS curve shifts left as represented by arrows in the graph. The IS₁ curve is the new equilibrium in the goods market affected by taxes. The shift occurred because of numerous outcomes, which started by the increase in taxes. Increase in income taxes leads to a decrease in disposable income, which consequently leads to a decrease in consumption. When consumption is in decline- so is the output and income. As shown in the graph output decreases from Y to Y₁. As the result of diminishing income, the demand for money is reduced, this, therefore, affects the interest rate, in a way that it decreases from i to i₁, as shown in the graph above.
In this case, the LM curve does not change, since in general fiscal policies do not affect the LM curve, this is because taxes do not appear in LM relation . However, the equilibrium between the goods and financial market does change. At point B the goods, market is at its equilibrium, but, the financial market is not, therefore, there is a need for adjustment, which is made along the LM curve to point A₁.
To sum up in words:
The increase in taxes leads to lower disposable income, which causes people to decrease their consumption. This decrease in demand, leads in turn, to a decrease in output and income. At the same time, decrease in income reduces the demand for money, leading to a decrease in interest rate. The decrease in the interest rate reduces, but doesn’t completely offset the effect of higher taxes on the demand of goods. Interest rate, may decrease investments.
In the medium run
For the sake of showing the effect of contractionary fiscal policy on US economy in the medium run, the AS-AD model will be used, since IS-LM is only appropriate to show the effects in the short run.
GRAPH 2
To avoid repetition of effects of fiscal contractionary policy in the short run mentioned in previous section , short run effects on AS and AD curves will not be mentioned. It is important to mention that the points A and A₁ in graph 2 correspond to the point A and A₁ in the graph 1, which means that the economy is at the point A₁.
As mentioned before, the output(Y) in the short run decreases to Y₁. Also the price level (P) declines to P₁ because of the low disposable income. What happens in the medium run is that the output (Y₁) returns to natural output(Yn), which corresponds to Y in graph 1. At this point the equilibrium of goods and financial markets changes from A₁ to A². The price level and the interest rate are lower than before the policy was applied. Also the interest rate declines even more as seen in the GRAPH 3.
GRAPH 3
Fiscal policy more powerful under fixed exchange rates
IS relation: Y= C (Y-T) + I (Y, i) + G
LM relation: M/P=YL(i)
b)
Yes, it is possible to change the natural rate of unemployment; there is a couple of ways to do that:
First one is an increase in unemployment benefits. This means that more people will consider the need of working. As we can see Price Setting (PS) is stable but Wage Setting (WS) is shifting upwards, this means unemployment is increasing this changes natural rate of unemployment, but the real wage hasn’t changed.
GRAPH 4 (Taken from the lecture slides)
And the second one is an increase in mark-up. When there is less competition in the economy the real wage goes down and unemployment goes up.
GRAPH 5 (Taken from the lecture slides)
Question 2
a)
The main consequence that occurs from introducing a tax on a specific market is deadweight loss, GRAPH 6 below explains it. Tax on a market affects both labour and product markets, because someone has to pay tax, it could be either buyers, suppliers, workers and companies.
GRAPH 6
The intersection of supply and demand at point A is the initial market equilibrium. Q1 represents quantity before the tax was introduced, and P1 represents the price before the tax. The triangle, which is formed by points P1, A and B represent the initial consumer surplus- consumer’s gain from trade before the tax. The triangle, which is formed by points P1, A and C represent the initial producer surplus- producer’s gain before the tax. The wedge ↨ represents the newly introduced tax. Once the tax is introduced by the US government price for the buyer increases (from P1 to P3), quantity exchanged has decreased from Q1 to Q2. Consumer surplus decreases from triangle, formed by points P1, A and B to triangle, formed by points P3, A2 and B. Producer surplus also decreases due to decrease in price at which they can sell, from P1 to P2. The new producer surplus is the triangle, formed by points P2, A1 and C. The area P3, A2, A1 and P2 is the tax revenue the government receives from the trades which occurred. The triangle A2, A, A1 is the deadweight loss, this means lost gains from trade. This means that if there was no tax, trades would have occurred, and people would have benefited from this, but now nobody gains from it.
Consequences of introducing a tax on product market:
Elastic products
GRAPH 7
As we can see in GRAPH 7 P1 shows the initial price on the product, before the tax. When a tax is added (represented by yellow tax wedge), the price rises from P1 to P2. The area in the graph showed as tax revenue occurs, this is what the government gets from taxing the market. However, the downside is that deadweight losses occur, where there used to be trade. Deadweight losses are larger the more the product, on which the tax is put on, is elastic. In general the more elastic the curve, the less tax has to be paid. In the GRAPH 7 I’ve given an example, where all the tax has to be paid by buyers, even though the demand curve is elastic, the supply curve is perfectly elastic, which means that suppliers have many substitutes, while buyers less, thus they are forced to buy the goods at the increased price. However, because of the fact that the tax was imposed on a very elastic good, the bigger deadweight loss occurs, so as we will see in the next graph, it makes more sense economically to tax inelastic goods, since less deadweight loss occurs.
Inelastic products
GRAPH 8
In GRAPH 8 the same case is showed only with very inelastic demand curve. It is very well shown that deadweight loss is a lot smaller in this case, because the demand is very inelastic- buyers do not have many substitutes for this product, so they have to buy the needed products at the increased price. From an economic standpoint it makes more sense to tax less elastic goods in order to reduce the deadweight loss.
Consequences of introducing a tax on labour market:
• Increased unemployment.
If there is a very high tax on a product, which leads to lower sales, this could affect the labour market negatively, since there is a lower demand for that product, there is a need for less labour, therefore if the demand falls drastically it will result in a lot of people losing jobs in that market. For example, if the US government is imposing tax on yacht market, which seems reasonable at first, since it is an inelastic product, but if the tax is high it can decrease the demand in yachts in the US, and people interested in buying them would either buy them abroad, wait to see if the tax was repealed or become uninterested altogether. Either way, the drop in demand of yachts means that there is lesser quantity needed, therefore fewer workers are needed to manufacture them, which means that a lot of people could become unemployed. Ironically, the US government would this way spend a lot of their gained tax revenue to give unemployment benefits to people who lost jobs because of the imposed tax.
• Lower/ higher wages.
Elastic
GRAPH 9 (Taken from the lecture slides)
The burden of the tax, similarly like with the product market, depends on how elastic demand and supply is. So in this case the supply curve is a lot more elastic, therefore suppliers pay more of the tax.
Inelastic
GRAPH 10 (Taken from the lecture slides)
b)
Public goods need to be provided and financed by government because of the following reasons:
a) Usually public good is provided by government and not private sector because they would be unable to supply them for a profit.
b) Government decides what output of public goods is approved by society.
Non-rival consumption: is when marginal cost of supplying a public good to a person is zero. This means that it is available for all because it is supplied for one person.
Non-excludable goods: are goods that everyone is able to use despite the fact that they haven’t payed for that good (free-rider problem). With private goods the consumption depends on ability to pay for it.
Non-reject able: a public good that can’t be rejected by people, for example flood defence projects.
Usually when goods are non-rival and non-excludable they are called pure public goods
Sometimes private companies can provide non-rival, non-excludable goods, sometimes private companies find a profitable way, example tv and radio, they cover a cost by selling airtime to advertisers.