Question

Use the classical IS–LMmodel to analyze the effects of a permanent increase in government purchases of 100 per year (in real terms). The increase in purchases is financed by a permanent increase in lump-sum taxes of 100 per year.

a.Begin by finding the effects of the fiscal change on the labor market. How does the effect of the permanent increase in government purchases of 100 compare with the effect of a temporary increase in purchases of 100?
b.Because the tax increase is permanent, assume that at any constant levels of output and the real interest rate, consumers respond by reducing their consumption each period by the full amount of the tax increase. Under this assumption, how does the permanent increase in government purchases affect desired national saving and the IScurve?
c.Use the classical IS–LMmodel to find the effects of the permanent increase in government purchases and taxes on output, the real interest rate, and the price level in the current period. What happens if consumers reduce their current consumption by less than 100 at every level of output and the real interest rate?

Answer 1

Step-by-step explanation:

A. The effect of a permanent increase in government purchases is different from that of a temporary increase.

I case of a permanent increase, the income effect is more as compared to that of a temporary increase. This happens because in case of a permanent increase, the present value of taxes is high in order to pay for the added government purchases. Hence, labor supply increases more in case of permanent change.

B. When consumption falls by the equal amount of taxes, there will be no change in the desired national savings. As a result, there will be no shift in the savings curve. If investment is also not changed or affected, The IS curve would not shift.

C. When there is a permanent increase in government purchases and taxes, the supply of labor will increase, thus shifting the FE curve to the right. In order to restore equilibrium back in the economy, the price level must decline, shifting LM curve to the right. As a result, output increases and interest rate falls.