Answer to Question #118899 in Macroeconomics for Mahmut

Question

A1. Tikea is an open economy with high capital mobility and a fixed exchange rate against
Euro. Prices are given in the short run. The Tikean government is currently debating a large
cut in the autonomous part of its income taxes to fight the current pandemic.
a) Analyze the effects of such a temporary tax cut graphically and verbally. Explain what
would happen to the following for Tikea: short run equilibrium income, interest rates,
investment, the value of Tikean Lira (consider Tikea as the domestic economy and use ETL/€
for Tikean Lira/Euro exchange rate), the net exports, the level of capital inflows and the
level of foreign exchange reserves at the central bank. Make sure you explain the
mechanism(s) behind your results.
b) How would your answer to part a) change if there is low capital mobility?
c) Now analyze the long run effects of a permanent tax cut (again assume high K-mobility).
You should explain both the short run and long run adjustments of the macroeconomic
aggregates in part a)

Answer 1

a) If the goverment reduce taxes the money supply increase as saving as demand as aggregate supply and of course prices. But at same time the interest rate doesn't change. The high prices increase import. If the government expenses doesn't change the government budget will be negative.

b) If capital mobility is low, AD and IS increase only

c) In the long run if the government doesn't decrease expenses economy will develop faster. But the budget need to find a way to make up for the deficit.