Question

Macroland is a small open economy with perfect capital mobility and a fixed-exchange-rate system. Macroland is initially in the long-run equilibrium at the natural level of output with balanced trade. With the help of an appropriate diagram,

compare the impact of a tax cut in the short run (when prices are fixed) and in the long run (when prices are flexible) on:

1. Output,

2. Consumption,

3. Investment,

4. Net exports

5. Exchange rate.

Answer 1

If there is a tax cut in short run will increase the disposable income and encourage the business level hiring and increase the level of investment. The price level is fixed in short run. So the price will not have any impact with market changes. The output will increase with shift in aggregate demand curve. The tax cut induce the level of consumption with rise in disposable income. The investment also increased. With constant price the net exports will increase. The higher level of investment reduces the interest rate and this will leads to reduction in exchange rate. This will reduce the value of domestic currency. This will make the import more expensive and the export become cheaper. So the net export will rise and this will leads to economic development. AS Price level P+ AD AD' Output In long run, the aggregate supply curve is vertical. The output will not change with respect to change in price level. With a cut in tax rate, the aggregate demand will shift to right. This will raise the price level and the output remains same. With constant money supply, the consumption will increase and the investment also. With flexible price the rise in investment will reduce the interest rate. These flexible prices the net export will increase and fall in exchange rate. LRAS Price level Pd AD' P1 AD Y* Quantity