Consider a small open economy in the short run where the government decreases th
ID: 1199510 • Letter: C
Question
Consider a small open economy in the short run where the government decreases the tax rate.
(a) Given a floating exchange rate sketch a graph of the impact of the tax decrease
(b) What direction (+/-/or no change) does the tax decrease impact: Y, Money Demand, r, e, and C
(c) Given a floating exchange rate sketch a graph of the impact of the tax decrease
(d) What direction(+/- or no change) does the tax decrease impact: Y, Money demand, r,e and C
(e) You own a hat company which sells both domestically and abroad. Therefor your total sales are a funtion of the exchange rate and total domestic consumption. Which regime would tour prefer in the case?
Explanation / Answer
IS curve: Y = C(Y-T) + I(r*) + G+ NX(e)
LM curve: M/P = L(r*,Y)
where C=consumption
T = tax
Y = income/output
M = money supply
P = price
G = government deficit
NX = net export
e = exchange rate
r = interest rate
a)
With decrease in tax, both consumption and government deficit increases, thus IS curve shifts from IS1* to IS2*. LM curve will remain at LM1*. Thus we can see that output will not increase as exchange rate apreciates which in turn will lead to decline in net exports in equal proportion.
b) Income will not change, money demand will not change, r will not change, e will appreciate and C will increase.