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Consider the following hypothetical conversation between three economists about the effects on the economy of a permanent increase in direct taxes on…

Consider the following hypothetical conversation between three economists about the effects on the economy of a permanent increase in direct taxes on labour income: ECONOMIST 1: “This policy is contractionary and disinflationary, but only in the short run.” ECONOMIST 2: “The tax increase will have an inflationary effect that will make the central bank put the brake on the real economy. Most of the contractionary effect will be permanent.” ECONOMIST 3: “This measure will not have any effect on inflation and, therefore, no consequences for monetary policy will follow.” Go to the macroeconomic simulator accompanying the Carlin and Soskice textbook. Use the closed economy version and make sure you start from scratch, that is all shocks are reset. In the simulator, implement the appropriate shock(s) and evaluate the validity of each economist’s claim. Can you reconcile their different views? (Hint: consider that this policy may have both demand and supply effects.) (12 points)

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