An explanation that may explain the lower labor supply in Europe besides taxes is one that Europeans may place a higher weight on leisure relative to working in their preferences than their American counterparts. This would mean that the indifference curves lean more towards the leisure axis than they lean towards the consumption axis, as is the case in Figure 3. Thus, when the price of leisure falls (I. E. Leisure becomes more affordable), Europeans are more willing to substitute out of consumption (and labor supply) and into leisure.
Problem Set 2: Suggested Solutions Taxes in the Real International Model (40 Raw Points) Taxes in the Real International Model This problem studies the effects of a permanent (lump sum) tax decrease on macroeconomic variables such as This problem studies the effects of a permanent (lump sum) tax decrease on macroeconomic variables such as unemployment’s, output, consumption, investment, interest rates, and real wages. This problem is particularly meet, output, consumption, investment, interest rates and real wages. Good preparation for the midterm! ) First, we study the effect of such a tax decrease on the consumption-leisure choice n isolation; therefore, use the consumption-leisure diagram to illustrate the effects of a lump-sum tax decrease on the optimal consumption and leisure choice. Make sure you illustrate income and substitution effects. (10) We analyze the effect of a lump-sum tax cut from TTL to TO on the consumption-leisure choice in isolation. Figure 3 shows that a permanent tax cut increases a consumers lifetime wealth, shifting the consumers budget set up by the amount of the tax decrease (I. . By TTL – TO Since the (lump-sum) tax cut does not change the real wage directly, the slope of the new budget constraint is fixed. As a result, there is no substitution effect. The tax cut, however, yields a pure income effect. Both current consumption and leisure increase as they are considered normal goods. Higher consumption of leisure means lower labor supply for a given real wage. Hence the optimal consumption and leisure moves from the leisure-consumption bundle (II , CLC ) TTT(12 , co ), while the utility level increases from II to 12.
Figure 3: A Decrease in Lump-Sum Taxes from TTL to TO 2) How will this change affect the labor market and the aggregate supply curve? Make sure to illustrate how the labor market and the aggregate supply curve are related. 6) As we saw in the above question, a decrease in lump-sum taxes increases leisure. However, increasing leisure is tantamount to decreasing labor supply for a given real wage. The effects of this change can be seen in the graph of the labor market in Figure 4(a). A decrease in lump-sum taxes increases the wealth of households and Macroeconomics – Problem Set By Copulated in.
In order to restore equilibrium in the labor market, the real wage increases from WI tow and the equilibrium level of labor falls from IN to NO . Hence, a permanent tax cut yields lower employment in the labor market. As a consequence, the firm produces less output at fixed level of capital stock (K) and total factor productivity (z) . This effect is a movement along the production function in the downward direction, as seen in Figure 4(b). Tracing the change over to the aggregate output market shown in Figure 4(c), the aggregate supply curve shifts to the left for every r from Y Is to Yes .
The labor market and the aggregate output market are linked via the firms production function. Figure 4: The Real International Model (a) The Labor Market (b) The Production Function (c) The Aggregate Goods Market decreases the need to work. Thus, for a given real wage, the labor supply curve shifts 4 3) Next, we study the effect of such a tax decrease on the international consumption choice in isolation; therefore, use the “consumption today – consumption tomorrow’ diagram to illustrate the effects of a lump-sum tax decrease on the optimal consumption path, c and c .
Make sure you illustrate income and substitution effects. To make your life simple, assume that the government keeps government spending in both periods as before and borrows what it needs in such a way that taxes are not raised in the lifetime of the currently living consumers to pay off the debt. The government essentially rolls over this debt. (10) We now analyze the effect of the lump-sum tax cut on the international consumption choice in isolation. A permanent lump-sum tax cut raises a consumers net income both today (I. E. Y – T increases) and tomorrow (I. . Y – T increases), thereby moving the consumer’s endowment point from El to EH in Figure 5. Clearly, a consumers lifetime wealth increases, and the distance between the new budget line and the old budget line is equal to the change in the lump-sum tax. Since r is unchanged by the lump-sum tax cut, there is no substitution effect. The lump-sum tax cut creates a pure income effect, however, and the consumer responds by raising consumption in both periods. The effect of this tax cut is characterized by the movement from point A to point B in Figure 5.
As the equilibrium level of consumption rises in both periods the indifference curve shifts out from II to 12 , resulting in a higher level of utility for the consumer. Figure 5: The Effect of a Decrease in Lump-Sum Taxes on the International Consumption Choice 4) How will the change under 3) affect the aggregate demand curve? (4) A permanent tax cut raises consumption in both periods. Hence we shift the aggregate demand curve to the right, as seen in Figure 6. It is important to distinguish this effect from any changes in consumption induced by a change in the real interest rate.
The latter case can be captured by the movement along the demand curve. On the other hand, any changes in consumption due to a tax policy shift the aggregate demand curve. 53 Figure 6: The Effect of a Decrease in Lump-Sum Taxes on Aggregate Demand 5) Taking your results in 1)-4) together, what are the predictions for employment today, output today, investment, interest rates, and real wages today in the new equilibrium. Assume that the economy is in equilibrium when the taxes are decreased. (10) Hint 1: Some of these changes may be ambiguous.
Hint 2: Be sure to include the second round effects on changes in the real interest Since the aggregate supply curve shifts to the left and aggregate demand curve shifts to the right, the real interest rate rises unambiguously. However, the effect on the equilibrium output is ambiguous. If the demand curve shifts less than the supply curve, the equilibrium output level will be lower at point B. This case is depicted in Figure 6. Changes in the interest rate, however, affect other macroeconomic variables in the economy, and we have to consider these second round effects.
Be sure to distinguish the second round effect from the first round effect under which the real interest rate was fixed at RL . More specifically, the first round effects are the direct effects that a decrease in lump-sum taxes have on the key macroeconomic variables, while the second round effects are the effects that a change in the interest rate (resulting from the lump-sum tax decrease) have on the key macroeconomic variables. The first round effects are summarized in the following table: Macroeconomic Variable Employment (N) Real Wage (w)
Consumption (c) Investment (l) First Round Effect Due to a Decrease in Lump-Sum Taxes Decrease Increase Unchanged An increase in the interest rate from RL to re creates the three following second round effects: (1) r t (Note: S. E. >I. E. ) (3) r NSA t (Note: There is a positive relationship between r and N s through international substitutions of leisure between I and I . ) 6 Lower consumption and investment and higher labor supply are all induced by a higher real interest rate. It is important to observe that the r induced changes in c and I do not shift the output demand curve.
Similarly, the r induced changes in N s o not shift the aggregate supply curve, either. These effects are captured by the movement along the demand and supply curve, respectively. Hence all three effects are already incorporated at the new equilibrium point B in Figure 6. However, the change in labor supply decision based on the higher real interest rate shifts the to answer part (2), we obtain the following result. When the labor supply curve shifts back, we obtain an ambiguous result in terms of changes in equilibrium employment and real wage. The result ultimately depends on how far the labor supply curve shifts back at the end.
In Figure 7, we show that the second round effect from higher real interest rate on labor supply does not completely offset the first round effect on labor supply resulting from the tax cut. Hence the equilibrium employment is lower, and real wage is higher. Figure 7: The Second Round Effect of an Increased Interest Rate in the Labor Market The following table sums up the second round effects due to the increase in the interest rate: Second Round Effect Due to an Increase in the Interest Rate Increase It is true that both output and employment may be higher or lower at the new equilibrium than at the original equilibrium.
