ECO 106 ASSIGNMENT II 1. We want to study how lower taxes will affect GDP and the price level if the economy starts out with cyclical unemployment.

ECO 106              ASSIGNMENT II

1.    We want to study how lower taxes will affect GDP and the price level if the economy starts out with cyclical unemployment. For each question, mark clearly the axis, the curves, and the equilibria.

(i)            Draw the aggregate demand curve and the short and long run supply curves for a country in one diagram. Assume that the country starts out in a situation with cyclical unemployment.

(ii)           What is the problem with the current situation?

(iii)          Assume that the government decides on a fiscal policy plan of reducing taxes to households. Illustrate in your diagram the effect on the economy of lower taxes by shifting the curve(s). Mark the new short-run equilibrium after lower taxes P2, Y2.

(iv)          How will the long-run equilibrium differ from the short-run equilibrium? (if it does) Explain briefly.

(v)           What was the effect of the reduction in taxes on output and the price level in the short and the long run?

2.    We now want to study the same fiscal policy if the economy starts at full employment.

(i)            Draw the aggregate demand curve and the short and long run supply curves for a country in a new diagram. Assume that the country starts at full employment.

(ii)           The government decides to reduce taxes to households. Illustrate in your diagram the effect on the economy of lower taxes by shifting the curve(s). Mark the new short-run equilibrium after lower taxes P2, Y2. What happened to output and the price level? What is the situation in the labor market in the new short-run equilibrium? (Is unemployment high/low?)

(iii)          Show what will happen to this economy in the long run and explain briefly. In the end, what was the change in output and prices from before the tax reduction to the new long run?

3.      Show the equation for the government budget. If the government started out with a balanced budget, what will be the effect on the budget of lowering taxes? What will happen to the government debt?

4.      The US is about to implement a new tax plan with a lower overall tax level. We saw above that the effect of lower taxes may depend on the state of the economy at the outset. Go to bls.gov and look under "Latest numbers" on the right hand side.

(i)            What is the unemployment rate for February? (To be released on the first Friday in March.)

(ii)           What was the inflation rate for "all items" and "all items except food and energy" for the 12-month period finished in Jan. 2018? (measured by the CPI) (follow link to CPI summary to find this info.)

(iii)          Do these unemployment and inflation numbers indicate that we are closer to the situation described in question 1 or question 2 above? Explain briefly.