Question 1 The the government wishes to cut taxes. Suppose you are a policy analyst working for the Central Board of Revenue (CBR), and it is your job to analyze the macroeconomic effects of a permanent tax cut. Suppose you have worked out the following very simplified model to characterize basic features of the Pakistani economy: Y = 4K + 5L K=1000 and L= 800 G = 3000 T = 3000 I = 2000 - 6000r C = 600 + .6(Y-T) a) First find the equilibrium levels of the interest rate, investment and consumption for the economy described for the equations above. (Assume a closed economy: Y = C + I+ G). b) Discuss the effects on the economy of lowering the level of T by 10%. You should compute the new equilibrium values of the interest rate, consumption and investment. By how much would investment be crowded out by the tax cut? c) Discuss briefly the intuition for why the investment equation above includes the interest rate with a negative sign. Discuss how it might be sensible for consumption to be negatively affected by the interest rate in a way similar to investment. If consumption did behave this way, use your intuition and economic reasoning to make an educated guess about how it would affect the degree to which the tax cut crowds out investment: more, less or the same. Explain your reasoning. d) Test your guess above by trying the following example: C = 600 + .6(Y-T) - 3000r, where you keep the other equations in the model the same as in part (b) above. Compute the equilibrium value of investment before and after the tax cut, and compare the amount by which investment is crowded out to what you found in part (b)