03 Jun Question Opinion How to Energize a Lackluster Recovery Allowing the full and immediate deductibility
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
wages are pro-cyclical, consistent with the business cycle facts. In the space below, draw two
diagrams vertically with a production function on top and a labor market diagram on the bottom.
Start at point A and then show specifically, why wages are pro-cyclical in this RBC model. Make
sure you explain exactly why wages change the way in a profit maximizing context (and label
diagram completely). Also explain why workers change their labor supply decision(s). Using an
aggregate supply / aggregate demand diagram, show that wages are indeed pro-cyclical by
mapping points A and B from the production function / labor market diagram to the AS / AD
diagram. Use and refer to your diagrams as to the cyclicality of average labor productivity and the
general price level. Are wages and average labor productivity ever counter-cyclical in the RBC
model? – if so, label as point C on your production function / labor market diagram. Please tell a
story about this counter-cyclical real wage just like a RBC economist would. Be very specific.
Finish your essay by explaining how the real business cycle economists explain unemployment
and variations in the unemployment rate.
f) (20 POINTS) The new Keynesians showed that wages are sticky and pro-cyclical. They also
showed that the existence of involuntary unemployment is a normal phenomenon. In the space
below, use the theory and the appropriate graphs that the new Keynesians use to explain the
stickiness, the pro-cyclical nature of the real wage, and the existence of involuntary
unemployment. Be sure to explain precisely how the wage is determined in this model and the
intuition underlying the sticky and pro-cyclical nature of the real wage. Finally, use the
appropriate diagram to show that employment is pro-cyclical. To do so, start at full employment
at point A and consider an adverse shock to aggregate demand (point B). Now explain why
employment fell and discuss what Keynes would prescribe to fix the problem and get us back to
full employment. Why did Keynes favor fiscal policy over monetary policy?
DO THIS QUESTION IF A TAILS IS FLIPPED
2. Christina Romer and Jared Bernstein in "The Job Impact of the American Recovery and
Reinvestment Plan" calibrated the impact of the proposed expansionary fiscal policy (we know it
as an increase in G and/or a lower T) on jobs and GDP growth (Click Here for paper). In order to
do so, they make assumptions about the size of Government spending and tax multipliers. One
important assumption is contained in the paragraph below about the level of the federal funds
rate:
" For the output effects of the recovery package, we started by
averaging the multipliers for increases in government spending and
tax cuts from a leading private forecasting firm and the Federal
Reserves FRB/US model. The two sets of multipliers are similar
and are broadly in line with other estimates. We considered
multipliers for the case where the federal funds rate remains
constant, rather than the usual case where the Federal Reserve
raises the funds rate in response to fiscal expansion, on the
grounds that the funds rate is likely to be at or near its lower
bound of zero for the foreseeable future."
So in this question, we are going to employ some of the tools that we have acquired throughout
the semester to understand how this assumption, "that the funds rate is likely to be at or near its
lower bound of zero for the foreseeable future," effects the government spending and tax
multipliers.
2. a) ( 40 points total: 20 points for correct and completely labeled graphs and 20 points for
discussion) In this question, we are going to compare the size of the Government spending
multiplier under two different assumptions: i) the Fed sits on their hands so that when G rises, r
rises with it (the standard case), and ii) the Fed accommodates the (real) shock to money demand
so that real interest rates remain constant.
In the space below, draw 4 diagrams (label them 1 through 4) with 1) a closed economy desired
saving; desired investment diagram, followed by 2) an IS LM diagram followed by 3) a money
market diagram followed by 4) an aggregate supply ; aggregate demand diagram.
We begin at our initial point A which is at an output well below potential GDP (i.e., there is a
significant ‘output’ gap). We let G rise and with the assumption that the Fed sits on their hands
(assumption i) above) we move to point B, which corresponds to an output closer to potential
GDP, but still not quite there. We then assume assumption ii) above so that the Fed
accommodates the real shock to money demand to keep real interest rates constant. This
assumption takes us to point C, which is at potential GDP (i.e., the output gap is gone!).
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
importantly that we are assuming fixed prices throughout this exercise. Now let G rise to G’ and
show how all your graphs are affected. In particular, locate point B in all graphs making sure
you refer to each graph separately explaining the intuition of the movement from point A to
point B. Note, we are assuming assumption i), the Fed sits on their hands and does not
accommodate the shock to real money demand.
@rb when Ma ^ to Mc with
Too much money! Buy bonds.
Lower interest at point C and higher output at point C. Point C must be in the southeast of point B
(money market). (3rd graph)
Money market is at a lower interest rate and a higher output (2 nd graph). Combination of
expansionary and fiscal policy
Increase output
2. b) (20 points for explanation) We now apply assumption ii), the one Romer and Bernstein use
"that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future." In
terms of our analysis, the Fed is going to make sure that real rates remain at their initial level (i.e.,
they totally accommodate the real shock to money demand). Show this accommodation as point
C on all of your diagrams. Recall that we are at full employment/potential GDP at point(s) C.
Again, make sure you refer to each graph separately explaining the intuition of the
movement from point B to point C.
2.c) (20 points) Now compare the government spending multiplier under assumption i) no Fed
accommodation and ii) the Fed accommodates the real shock to money demand. Be specific with
regard to the multiplier as well as the intuition. To support your intuition, draw two diagrams: the
user cost = MPKf and the two period consumption model clearly locating points A, B, and C.
Referring to your 2 graphs, explain the intuition as to why we move from point A to point B as
well as why we move from points B to C. Be sure to label your graphs completely or points will
be taken off. Make sure you relate your discussion of your two graphs to the difference in the
multiplier depending on what the Fed does or doesn’t do.
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