Lecture 2, Exercise 3

Question: What do you think will happen to the steady state value(s) of output when θ changes? Why does this happen?

Answer: If the tax rate, θ, goes up, (assuming government expenditure remains the same) national income, Y, would decrease as would households disposable income and consumption. Since government expenditure must equal tax receipts in a steady state, the tax receipts will remain unchanged. The perfect foresight national income equals government expenditure divided by the tax rate, i.e. Y* = G/ θ.