8. The diagram below shows an economy which operates with a flexible exchange ra
ID: 1161760 • Letter: 8
Question
8. The diagram below shows an economy which operates with a flexible exchange rate and is initially in short-run equilibrium at point 1, where Y- Y1 and E-El. El Now suppose there is a temporary decrease in taxes (&T;). Assume NO changes in any other exogenous variable. a) The effect of this temporary decrease in taxes is to shift the curve of the economy to the (increase/decrease) in equilibrium output (Y) and a(n) decrease) in the equilibrium value of the exchange rate (E) (right/left) resulting in a(n) (increase/ (4 marks) b) Explain why this decrease in taxes causes the equilibrium level of output (Y) to change in the direction you have indicated in answer to part a). (3 marks) c) Explain why this decrease in taxes causes the equilibrium exchange rate (E) to change in the direction you have indicated in answer to part a). (5 marks) d) Between the initial short-run equilibrium (point 1 in the diagram above) and new the short-equilibrium reached after the economy has adjusted to this decrease in taxes, will the amount of the current account balance (CA) of this economy have increased or decreased? Identify and explain the various causes of that change in CA. (3 marks) e) Now suppose that this decrease in taxes is a permanent one and is expected to be permanent. How will the effects of a permanent decrease in taxes on the positions of the DD and AA curves and the equilibrium levels of Y and E differ (if at all) from those you have identified in answer to part a) above? Explain. (5 marks)Explanation / Answer
Answer
a)
AA , Right , Increase , Increase
b) Decrease in Taxes will result in an increase in the consumption of the individuals as:
C = C + c*(Y-T)
where C is constant consumption when income is zero
As you can see from above equation decrease in taxes results in increase in personal desposable income hence increase in consumption and this increase in consumption results in increase in output.
c)
Increase in exchange rate is considered as the appreciation of our currency and our value of currency depends on our exports and imports. Now, as taxes decreases our output hence GDP of a country increasesand as every other thing remains constant, this leads to either decrease in imports or increase in exports and in either case this leads to increase in equilibrium exchange rate.
d)
Current account balance of this economy dereases beacause after decreasing taxes our exchange rate increases and this leads to appreciation of our currency. Because of this appreciation our goods are expensive for foreign consumers which leads decrease in exports. This decrease in exports will worsen our current account balance
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