NATIONAL UNIVERSITY OF SINGAPORE

Department of Economics
EC3102 Macroeconomic Analysis II
Prepared by Ho Kong Weng
Tutorial 6
Suggested answer to Question 1:
(a) Lower expected future interest rates, higher human and nonhuman wealth, and hence
higher consumption. Likewise, lower expected future interest rates, higher present value
of after-tax profits, and hence, and hence higher investment. Therefore, current private
spending increases. The IS curve shifts to the right.
(b) First, an increase in expected future taxes tends to reduce expected future after-tax
income (for any given level of income), and therefore to reduce consumption. In
other words, human wealth is reduced and consumption falls. This effect tends to shift
the IS curve to the left.
Second, the increase in future taxes (a deficit reduction program) tends to reduce real
interest rates in the future. The fall in the expected future interest rate tends to shift
the IS curve to the right because both human and nonhuman wealth are raised. See
the suggested answer to (a).
Third, and related to the above, a fall in the real interest rate in the future will increase
the present-value of after-tax profits, boosting investment. The IS curve will shift to
the right.
The following diagram is a good guide to the effects:

The net effect on the IS curve is ambiguous. Note that the basic model of the lecture
and textbook has lump sum taxes. If taxes are not lump sum, the tax increase may
Ho Kong Weng
Prepared by Prof. Ho and distributed to his TAs and
students for their benefits. Do not sell to, upload to,
or share with third party organizations or persons.

increase distortions in the economy. These effects tend to reduce output (or the
growth rate).
(c) A decrease in expected future income, either labor income, or dividend income, will
reduce human wealth, or nonhuman wealth, implying lower consumption and
investment. Therefore, current private spending decreases. The IS curve shifts to the left.
Suggested answer to Question 2:
(a) In the medium run, budget deficit reduction will lead to higher savings and higher
investment. Real interest rate is lowered in the medium run.
Point to ponder: In the medium run, how is the composition of output changed given
a budget deficit reduction? Hint: Check your answers for earlier tutorials.
In the long run, higher investment is translated to capital accumulation, higher capital
stock and hence higher output.
(b) Brief review: A cut in G will shift the current IS curve to the left; expected future
output increases and shift the current IS curve to the right; expected future real
interest rates go down and shift the current IS curve to the right. The combined effects
have an ambiguous impact on the net shift of the current IS curve.

Advantage: Backloading the budget reduction program toward the future may make the
leftward shift of the current IS curve small, and make the rightward shift of the current
IS curve big. Current output is more likely to increase as a result.
Disadvantage: Backloading may reduce the credibility of the program to cut
governments budget deficit in the future when the current cut, like a signal, is very
small. A loss in credibility will reduce the magnitude of the expected increase in future
output and the expected fall in future real interest rates.
(c) The gesture seemed to indicate that the Fed supported deficit reduction, and was
willing to conduct expansionary monetary policy in the future to offset the direct
Ho Kong Weng
Prepared by Prof. Ho and distributed to his TAs and
students for their benefits. Do not sell to, upload to,
or share with third party organizations or persons.

negative effects on output from spending cuts and tax increases. A belief that the Fed
was willing to act in this way would tend to increase expected future output (relative
to the case where the Fed did nothing) and to reduce expected future interest rates.
Both of these effects would tend to increase output in the short-run or the present.

Ho Kong Weng
Prepared by Prof. Ho and distributed to his TAs and
students for their benefits. Do not sell to, upload to,
or share with third party organizations or persons.