Question

Suppose the government cuts taxes. Using the long-run model of a small open economy, graphically illustrate the impact of the tax cut on the real exchange rate. What happens to disposal income, consumption, national saving, real interest rate, investment, net capital outflow, real exchange rate, exports, imports, net exports, and real output?

Answer 1

A tax cut in a small open economy leads to an appreciation of the real exchange rate. It also increases disposable income and consumption, while decreasing national saving. Investment remains unchanged and net capital outflow decreases.

Step-by-step explanation:

In the long-run model of a small open economy, a tax cut by the government will have several effects. Let's start with the impact on the real exchange rate. A tax cut will increase disposable income, leading to an increase in consumption. This increase in consumption will lead to an increase in imports since consumers are spending more on foreign goods, which will in turn cause the real exchange rate to appreciate.

For the other variables:

• Disposable income, consumption, and real interest rate increase.
• National saving decreases.
• Investment remains unchanged.
• Net capital outflow decreases.
• Exports decrease.
• Imports increase.
• Net exports and real output decrease.