Question: Note : DO NOT SOLVE PART A. JUST B AND C ARE ENOUGH. Tikea is an open economy with high capital mobility and a fixed

Note : DO NOT SOLVE PART A. JUST B AND C ARE ENOUGH.

Tikea is an open economy with high capital mobility and a fixed exchange rate against Euro. Prices are given in the short run. The Tikean government is currently debating a large cut in the autonomous part of its income taxes to fight the current pandemic.

a) Analyze the effects of such a temporary tax cut graphically and verbally. Explain what would happen to the following for Tikea: short run equilibrium income, interest rates, investment, the value of Tikean Lira (consider Tikea as the domestic economy and use ETL/ for Tikean Lira/Euro exchange rate), the net exports, the level of capital inflows and the level of foreign exchange reserves at the central bank. Make sure you explain the mechanism(s) behind your results.

b) How would your answer to part a) change if there is low capital mobility?

c) Now analyze the long run effects of a permanent tax cut (again assume high K-mobility). You should explain both the short run and long run adjustments of the macroeconomic aggregates in part a).

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