03 Jun Question Opinion How to Energize a Lackluster Recovery
Question
Opinion
How to Energize a Lackluster Recovery
Allowing the full and immediate deductibility of capital investment would spur growth and raise wages.
Excerpts from article
Taxing investment reduces after-tax returns to investing. Investors care about
after-tax returns and a tax policy that lowers investment returns is especially
harmful to long-term economic growth..There are many changes that
would improve the efficiency of the tax code, but cutting the tax on investment
heads the list.
Mr. Lazear, chairman of the President’s Council of Economic Advisers from 2006-09, is a
professor at Stanford University’s Graduate School of Business and a Hoover Institution
fellow.
Please answer the following questions.
1. a) (30 POINTS) In this part you are to explain exactly how lowering the effective tax rate on
capital () will work (in theory) its way through the economy in order to "spur growth and raise
wages. In this discussion, you need to differentiate between the short- run and long-run. In the
space below, explain, with graphical analysis, how lowering the effective tax rate on capital will
influence real economic variables in the short run (hint, its a demand side story). Draw 4
diagrams (label them 1 through 4), with 1) a user cost ; desired capital (K*) diagram, followed by
2) a closed economy desired saving; desired investment diagram, followed by 3) an IS LM
diagram followed by 4) an aggregate supply ; aggregate demand diagram.
Start at an initial equilibrium and label as point A in all diagrams, with all the associated market
clearing variables denoted by subscript A. For example, in your IS LM diagram, the interest
rate that clears the goods and money market is labeled as r A with the associated output at YA.
Note that YA, our initial equilibrium output, is below full employment output = Y B (we are
in a recession, read on). Now let the effective tax rate on capital fall (same as a fall in ) and
show how all your graphs are affected. In particular, locate point B as the new short-run
equilibrium in all graphs (assume the standard; that is, let output rise to Y B = full employment Y)
while holding the general price level fixed at P A = PB. Make sure you refer to each diagram
individually explaining how and why we get to point B (i.e., provide intuitive economic
reasoning starting with how a lower effects K* and why)!). Be sure to include a discussion of
why the real interest rate has to change the way it does – hint, the money market!
b) (20 POINTS) Now we are going to focus on the idea that in the longer run, the influence of
the decrease in the effective tax rate on capital will have supply-side effects. In particular,
argue that this new investment, spurred on by the lower effective tax rate on capital, will result in
a positive productivity shock resulting in a higher A and K" which will result in a shift upward
in the production function (via increasing the MPK f and MPN!) In the space below draw a
production function with the labor market diagram below it and show what is going on in this
longer run. That is, locate the corresponding point B (from above), and then show the longer run
influence as point C in these two (supply side) diagrams. What happens to N* and w*=W/P?
Explain in detail. Are these results in the labor market consistent with sub-title of the article and
the business cycle facts? Now explain why output has changed, give two specific reasons. Note,
in this part of the problem, do not worry about identifying point A in the labor market diagram
and production function diagram since point A does not exist given the assumption that labor
markets always clear at full employment (i.e., a weakness of the classical model). Be sure to label
your graphs completely (relevant shift variables) or points will be taken off.
c) (20 POINTS) Now show how graphs 1) through 4) are influenced by this longer-run
development. Note again that we assume that before these longer run developments take hold,
the FE line in graph 3) and the LRAS in graph 4) is set at Y B. Now let these longer run
developments take hold, i.e., these supply side effects, and label this final equilibrium as point C.
Again, please make sure you refer to each diagram individually explaining how and why we
get to point C (i.e., provide intuitive economic reasoning!). Be sure to include a discussion of
why the real interest rate has to change the way it does – hint, the money market!
d) (20 POINTS) In the space below, discuss how the new classical economists (hint, island)
addressed the business fact that money and output are positively correlated. In this part, be
extremely specific in the model that was developed (tell a story) and relate the assumptions in the
model to the empirical fact above. Be sure to explain exactly why the firm changes their output,
using the terms: relative shock and aggregate shock. Use the bread making example that we used
in class making sure you identify clearly, the asymmetry with regard to the real wage the firm
pays and the real wage the worker receives. Include 2 graphs as we did in class and explain the
intuition as to why the workers change their behavior and why the boss (firm) changes their
behavior. Now draw an aggregate demand and aggregate supply diagram explaining how your
individual island analysis (as given above) maps to the macro economy (include points A, B, and
C as we did in class). Write out the expression for the Lucas aggregate supply curve explaining
the intuition underlying the Lucas Aggregate supply curve. In the last part of your essay, discuss
what determines the power of monetary policy (in terms of changing output) in this model,
what determines how long the short run is, and whether or not you believe that this model is
a solid basis for conducting countercyclical monetary policy. Finish the essay by commenting
on the following: This model was developed back in the 1960s and 1970s and it is now 2014.
Do you believe the model is more relevant or less relevant today relative to when it was written?
Explain.
e) (20 POINTS) The real business cycle economists (RBC) showed that in their model, real
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