policy implication of the classical Equilibrium model
- 1. POLICY IMPLICATION OF THE CLASSICAL EQUILIBRIUM MODEL CONTINUED…. By Shahid Munir
- 2. TAX POLICY; 1# DEMAND SIDE EFFECT A) Tax Cut: Let Govt reduces taxes, the disposable income of peoples will increased, as a result consumption will increase Let govt replaces its revenue lost by selling bonds to the public. Demand for loanable funds will increase. Interest rate will increase. Saving will increase, resulting crowding out effect.
- 3. Cont…. b) Printing new Money; Let Govt replaces its revenue lost by printing new money, this will increase money supply. The increase money supply will increase prices. Increase prices will increase aggregate demand.
- 4. Supply Side Effects Tax Cut: Let govt reduces marginal income tax rate1 . Let the initial marginal income tax rate is 40% and Govt reduces to 20%2 . Now every individual out of his income is paying less, in other words real income of individual increased. As we know that Ns = g (w/p). After tax deduction aggregate labor supply curve would be come 1 Marginal income tax rate is percentage of tax which person gives on his her income. i.e. T = To+ tY, where t is the marginal income tax. 2 T=To+0.4Y reduces to T=To+0.2Y
- 5. Conti…. Here aggregate labor supply is function of real wage(W/P), real wage increase will lead to increase ALS and vice versa. Let Ns= (1-tY)(W/p). Here ASL is function of tax rate and real wages. Tax rate will affect aggregate supply of labor. Lets explain it with following diagram.
- 6. Supply Side Effects Of Income Tax Cut a)Labor market equilibrium with changes in marginal income tax b)Production function c) Aggregate demand and supply MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment output Agreggatepriceleveloutput Yo Y1 No N1 Yo Y1 Y = F (K, N) Po P1 A B A B Yd ASo AS1 MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment Agreggatepriceleveloutput Yo Y1 No N1 Y = F (K, N) Po P1 A B A B Yd ASo AS1
- 7. The first diagram represents equilibrium In labor market, where basic equi: take place At point A, where Ns = Nd. W/P is real wage rate And No is the level of Employment. The second diagram represents the level of total output produce in economy, here with The level of employment No total output Produce is Yo. Third diagram depicts equilibrium level of output and prices, Po is equilibrium price And Yo, equilibrium quantity, determined by By the market forces(AD an AS). MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment output Agreggatepriceleveloutput Yo Y1 No N1 Yo Po P1 A B A B Yd ASo AS1 MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment Agreggatepriceleveloutput Yo Y1 No N1 Po P1 A B A B Yd ASo AS1 Y1
- 8. Let govt reduces marginal income tax rate to 20% (t = 0.2). As a result of such deccrease real wages of labor increases, this will induce labor to work more, as result ASL will shift to the right, as shown in figure a New eauilibruim will take place in labor market at point B,where N1 is equ level of Employenet and( W/P)1 is real wage rate. MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment Agreggatepriceleveloutput Yo Y1 No N1 Y = F (K, N) Po P1 A B A B Yd ASo AS1 MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment Agreggatepriceleveloutput Yo Y1 No N1 Y = F (K, N) Po P1 A B A B Yd ASo AS1
- 9. As result of such increase in employment Output will increase to Y1. This will shift the As supply to As1, as result Of increase in AS prices will decrease to P1. MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment Agreggatepriceleveloutput Yo Y1 No N1 Y = F (K, N) Po P1 A B A B Yd ASo AS1 MPN= Nd Ns (tY = 0.40) Ns (tY + 0.20) b (W/P)0 (W/P)1 No N1 Realwages Employment Employment Agreggatepriceleveloutput Yo Y1 No N1 Y = F (K, N) Po P1 A B A B Yd ASo AS1 Yo
Editor's Notes
- #5: Marginal income tax rate is percentage of tax which person gives on her income. i.e. T = To+ tY, where t is the marginal income tax