NATIONAL NATIONAL UNIVERSITY UNIVERSITY OF SINGAP SINGAPORE ORE Department of Economics EC3102 Macroeconomic Analysis II Prepared by Ho Kong Weng Tutorial 6 Suggested answer to Question 1:
(a) Lower expected future interest rates, higher human and nonhuman wealth, and hence higher consumption. Likewise, lower expected future interest rates, higher present value of after-tax profits, and hence, and hence higher investment. Therefore, current private spending increases. The IS curve shifts to t o the right. (b) First, an increase in expected future taxes tends to reduce expected future after-tax income (for any given level of income), income), and therefore to reduce consumption. In other words, human wealth is reduced and consumption falls. This effect tends to shift the IS curve curve to the left. Second, the increase in future taxes (a deficit reduction program) tends to reduce real interest rates in the future. The fall in the expected future interest rate tends to shift the IS curve to the right because both human and nonhuman nonhuman wealth are raised. See the suggested answer to (a). Third, and related to the above, a fall in the real interest rate in the future will increase the present-value of after-tax profits, boosting investment. The IS curve will shift to the right. The following diagram is a good guide to the effects:
The net effect on the IS curve curve is ambiguous. Note that the basic model of of the lecture and textbook has has lump sum taxes. If taxes are not lump sum, the tax increase may
© Ho Kong Kong Weng Pr epar ed by Pr of . Ho and di st r i but ed t o hi s TA TA’ s and and s t udent s f or t hei r benef i t s . Do not s el el l t o, upl oad t o, or sh sha ar e wi t h t hi r d par t y or gani zat zat i ons or or per son sons.
increase distortions in the economy. growth rate).
These effects tend to reduce output (or the
(c) A decrease in expected future income, either labor income, or dividend income, will reduce human wealth, or nonhuman wealth, implying lower consumption and investment. Therefore, current private spending decreases. The IS curve shifts to the left. Suggested answer to Question 2:
(a) In the medium run, budget deficit reduction will lead to higher savings and higher investment. Real interest rate is lowered in the medium run. Point to ponder: In the medium run, how is the composition of output changed given a budget deficit reduction? Hint: Check your answers for earl ier tutorials.
In the long run, higher investment is translated to capital accumulation, higher capital stock and hence higher output. (b) Brief review: A cut in G will shift the current IS curve to the left; expected future output increases and shift the current IS curve to the right; expected future real interest rates go down and shift the current IS curve to the right. The combined effects have an ambiguous impact on the net shift of the current IS curve.
Advantage: Backloading the budget reduction program toward the future may make the leftward shift of the current IS curve small, and make the rightward shift of the current IS curve big. Current output is more likely to increase as a result. Disadvantage: Backloading may reduce the credibility of the program to cut government’s budget deficit in the future when the current cut, like a signal, is very small. A loss in credibility will reduce the magnitude of the expected increase in future output and the expected fall in future real interest rates. (c) The gesture seemed to indicate that the Fed supported deficit reduction, and was willing to conduct expansionary monetary policy in the future to offset the direct
© Ho Kong Weng Pr epar ed by Pr of . Ho and di st r i but ed t o hi s TA’ s and s t udent s f or t hei r benef i t s . Do not s el l t o, upl oad t o, or shar e wi t h t hi r d par t y or gani zat i ons or per sons.
negative effects on output from spending cuts and tax increases. A belief that the Fed was willing to act in this way would tend to increase expected future output (relative to the case where the Fed did nothing) and to reduce expected future interest rates. Both of these effects would tend to increase output in the short-run or the present.
© Ho Kong Weng Pr epar ed by Pr of . Ho and di st r i but ed t o hi s TA’ s and s t udent s f or t hei r benef i t s . Do not s el l t o, upl oad t o, or shar e wi t h t hi r d par t y or gani zat i ons or per sons.
