DO THIS QUESTION IF A TWO IS FLIPPED #2 (70 points total) We recently discussed that investment in the US economy is weak and we also discussed how important investment is for living standards in the future (for both workers and firms!). An excerpt from a WSJ article dated 12/1/2015 is below: 11:59 am ET Dec 1, 2015 Business Cycles CEOs' Economic Outlook Dims as More Plan to Pull Back Investment "Companies are putting capital budgets together right now and don't have a clear line of sight on what their tax bill will be on those investments," he said on a call with reporters Tuesday. "When the tax code is uncompetitive, like ours is, it has the effect of incentivizing investment elsewhere" in the world. In this problem, we are going to assume that a 'supply sider' wins the election and immediately lowers the effective tax on capital to make our tax code MORE competitive (recall that the US has the second highest effective tax rate (on capital) in the world according to our textbook). a) (30 POINTS) In this part you are to explain exactly how lowering the effective tax rate on capital (1) will work (in theory) its way through the economy. In this discussion, you need to differentiate between the short- run and long-run. In the space below, explain, with graphical analysis, how lowering the effective tax rate on capital will influence real economic variables in the short run (hint, it's a demand side story). Draw 4 diagrams (label them 1 through 4), with 1) a user cost ; desired capital (K*) diagram, followed by 2) a closed economy desired saving; desired investment diagram, followed by 3) an IS - LM diagram followed by 4) an aggregate supply ; aggregate demand diagram. Start at an initial equilibrium and label as point A in all diagrams, with all the associated market clearing variables denoted by subscript A. For example, in your IS - LM diagram, the interest rate that clears the goods and money market is labeled as r, with the associated output at Y,. Note that Ya, our initial equilibrium output, is below full employment output = Y, (we still have slack in the economy, in fact the GDP gap is currently, as of Dec 2015, -3%). Now let the effective tax rate on capital fall (same as a fall in 1) and show how all your graphs are affected. In particular, locate point B as the new short-run equilibrium in all graphs (assume the standard; that is, let output rise to Y, = full employment Y) while holding the general price level fixed at PA =P - Make sure you refer to each diagram individually explaining how and why we get to point B (L.e., provide intuitive economic reasoning starting with how a lower t effects K* and why)!). Be sure to include a discussion of why the real interest rate has to change the way it does - hint, the money market