Assume that workers and firms behave as in the standard model we described in class. The government announces the following policy reform: (i) the labor income tax increases immediately; (ii) all proceeds will be invested in a much required infrastructure project that will permanently raise Total Factor Productivity (A) starting next period; (iii) the tax increase is calculated in a way that will keep workers’ PVLR unchanged (i.e the tax reform does not imply an income effect on labor supply).

1. What is the effect on the labor market in the short run? Explain whether or not the labor supply and labor demand curves shift, in which direction etc.

2. What is the effect on firms’ optimal future capital decision? what does it imply with regards to current investment? (you may assume that the effects of Af on MPKf dominate the effects of Nf on MPKf )

3. Describe the short run equilibrium in the goods market. Does the S curve shift? the I curve? what is the new level of r, what happens to consumption?

4. Describe the new equilibrium in the labor market in the long run. (You may assume that the demand effects dominate the supply effects).

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Policy Reform Analysis Labor Market Investment and Output Given Workers and firms follow the standar... View the full answer