Question

Suppose that the government decides to reduce taxes. In the model used in Chapter 5, determine the effects this has on aggregate output, consumption, employment, and the real wage, and explain your results.

Answer 1

In a one-period model, taxes must be exactly equal to government spending. A reduction in taxes is therefore equivalent to a reduction in government spending. This result is exactly the opposite of the case of an increase in government spending presented in the textbook. A reduction in government spending induces a pure income effect that induces the consumer to consume more and work less. At lower employment, the equilibrium real wage is higher because the marginal product of labor rises when employment falls. Output falls, consumption rises, employment falls, and the real wage rises.