Worth: Mankiw Economics 5e 414 PART V Microeconomic Policy Debates 75-3 The Traditional View of Government Debt Imagine that you are an economist working for the Congressional Budget Office (CBO). You receive a letter from the chair of the Senate Budget Committee Dear CBo Economist. Congress is about to consider the president's request to cut all taxes by 20 per- cent. Before deciding whether to endorse the request, my committee would like your analysis. We see little hope of reducing government spending, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country? Sincerely, Committee chair Before responding to the senator, you open your favorite economics textbook- this one, of course-to see what the models predict for such a change in fiscal cy o ana the long-run effects of this policy change, you turn to the els in Chapters 3 through 8. The model in Chapter 3 shows that a tax cut stimulates consumer spending and reduces national saving. The reduction saving raises the interest rate, which crowds out investment. The Solow growth model introduced in Chapter 7 shows that lower investment eventu- ally leads to a lower steady-state capital stock and a lower level of output. Be cause we concluded in Chapter 8 that the U.S. economy has less capital than in the golden Rule steady state(the steady state with maximium consump- tion), the fall in steady-state capital means lower consumption and reduced economic well-being To analyze the short-run effects of the policy change, you turn to the IS-LM model in Chapters 10 and 11. This model shows that a tax cut stimulates con- sumer spending, which implies an expansionary shift in the IS curve. If there is no change in monetary policy, the shift in the IS curve leads to an expansionary shift in the aggregate demand curve. In the short run, when prices are sticky, the expansion in aggregate demand leads to higher output and lower unemploy put,and the higher aggregate demand results in a higher price leve tate of out- ment. Over time, as prices adjust, the economy returns to the natural To see how international trade affects your analysis, you turn to the open- economy models in Chapters 5 and 12. The model in Chapter 5 shows that when national saving falls, people start financing investment by borrowing from abroad, causing a trade deficit. Although the inflow of capital from abroad lessens the effect of the fiscal-policy change on U.S. capital accumulation, the United States becomes indebted to foreign countries. The fiscal-policy change also causes the dollar to appreciate, which makes foreign goods cheaper in the United States and domestic goods more expensive abroad. The Mundell-Fleming model in Chapter 12 shows that the appreciation of the dollar and the resulting fall in net exports reduce the short-run expansionary impact of the fiscal change on Itput and employment User LUKBI: Job EFFo1431: 6264_ch15: Pg 414: 28044#/eps at 100s Wed,Feb20,20023:28User LUKBI:Job EFF01431:6264_ch15:Pg 414:28044#/eps at 100% *28044* Wed, Feb 20, 2002 3:28 PM 15-3 The Traditional View of Government Debt Imagine that you are an economist working for the Congressional Budget Office (CBO).You receive a letter from the chair of the Senate Budget Committee: Dear CBO Economist: Congress is about to consider the president’s request to cut all taxes by 20 per￾cent. Before deciding whether to endorse the request, my committee would like your analysis.We see little hope of reducing government spending, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country? Sincerely, Committee Chair Before responding to the senator, you open your favorite economics textbook— this one, of course—to see what the models predict for such a change in fiscal policy. To analyze the long-run effects of this policy change, you turn to the mod￾els in Chapters 3 through 8. The model in Chapter 3 shows that a tax cut stimulates consumer spending and reduces national saving. The reduction in saving raises the interest rate, which crowds out investment. The Solow growth model introduced in Chapter 7 shows that lower investment eventu￾ally leads to a lower steady-state capital stock and a lower level of output. Be￾cause we concluded in Chapter 8 that the U.S. economy has less capital than in the Golden Rule steady state (the steady state with maximium consump￾tion), the fall in steady-state capital means lower consumption and reduced economic well-being. To analyze the short-run effects of the policy change, you turn to the IS–LM model in Chapters 10 and 11.This model shows that a tax cut stimulates con￾sumer spending, which implies an expansionary shift in the IS curve. If there is no change in monetary policy, the shift in the IS curve leads to an expansionary shift in the aggregate demand curve. In the short run, when prices are sticky, the expansion in aggregate demand leads to higher output and lower unemploy￾ment. Over time, as prices adjust, the economy returns to the natural rate of out￾put, and the higher aggregate demand results in a higher price level. To see how international trade affects your analysis, you turn to the open￾economy models in Chapters 5 and 12. The model in Chapter 5 shows that when national saving falls, people start financing investment by borrowing from abroad, causing a trade deficit.Although the inflow of capital from abroad lessens the effect of the fiscal-policy change on U.S. capital accumulation, the United States becomes indebted to foreign countries. The fiscal-policy change also causes the dollar to appreciate, which makes foreign goods cheaper in the United States and domestic goods more expensive abroad.The Mundell–Fleming model in Chapter 12 shows that the appreciation of the dollar and the resulting fall in net exports reduce the short-run expansionary impact of the fiscal change on output and employment. 414 | PART V Microeconomic Policy Debates