Real Business Cycle Model The government of “Defitonia” only relies on lump-sum taxes to finance its expenditures, and is evaluating a fiscal consolidation plan to bring down its fiscal deficit. Two alternatives are being assessed: increasing current taxes, or cutting current government expenditures. In this problem, you will analyse both alternatives through the lens of the Real Business Cycle (RBC) model studied in class. (a) Suppose that the government of Defitonia increases current taxes, but does not change its level of spending in either period. What are the effects of the tax change on the real wage, employment, the real interest rate, and output? Explain by using the equilibrium diagrams for the current labour market and for the current goods market in the RBC model. (b) Now suppose that the government of Defitonia cuts current government spending. What are the effects of the tax change on the real wage, employment, the real interest rate, and output? Explain by using the equilibrium diagrams for the current labour market and for the current goods market in the RBC model. (c) The Prime Minister of Defitonia is concerned about how the policy analysed in part (2) could impact the price level. In particular, he claims that “a government spending cut will unambiguously lead to a deflation.” Evaluate the validity of this statement by using the equilibrium diagram for the money market in the RBC model with money (assume that prices are fully flexible)
Real Business Cycle Model
The government of “Defitonia” only relies on lump-sum taxes to finance its expenditures, and is evaluating a fiscal consolidation plan to bring down its fiscal deficit. Two alternatives are being assessed: increasing current taxes, or cutting current government expenditures. In this problem, you will analyse both alternatives through the lens of the Real Business Cycle (RBC) model studied in class.
(a) Suppose that the government of Defitonia increases current taxes, but does not change its level of spending in either period. What are the effects of the tax change on the real wage, employment, the real interest rate, and output? Explain by using the equilibrium diagrams for the current labour market and for the current goods market in the RBC model.
(b) Now suppose that the government of Defitonia cuts current government spending. What are the effects of the tax change on the real wage, employment, the real interest rate, and output? Explain by using the equilibrium diagrams for the current labour market and for the current goods market in the RBC model.
(c) The Prime Minister of Defitonia is concerned about how the policy analysed in part (2) could impact the price level. In particular, he claims that “a government spending cut will unambiguously lead to a deflation.” Evaluate the validity of this statement by using the equilibrium diagram for the
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