Chapter 13, Problem 2P

To determine

The reason why neither real GDP nor the price level changes significantly after a tax cut

Concept introduction:

Permanent Income Hypothesis- Permanent Income is the long term average income of the people. Wealth (W), defines the present discounted value of the present and future income receipts. The Permanent Income Hypothesis (PIH) assumes that if the level of income is received in perpetuity, known as infinite life of the household, equals the wealth of the household. The disposable income (Y) is further read as an aggregate of Permanent Income (Yp) and Transitory Income (Yt).

$Y=Yp+Yt$ .

The transitory component reflects the income fluctuations. The expected value of the transitory component is 0 in the long run upholding the expectation that in the long run transitory gains are offset by transitory losses and vice versa.