Principles of Macroeconomics

Suppose you are on the President’s council of economic advisors. Due to the sluggish pace of
economic activity, the President is considering impl e menting a temporary tax cut in the hope t h at
it will encour age a subs tantial increase in aggregate consumption spending and thereby lead to
more vigorous growth in a ggregate economic activity and a reduction in the rate of
unemployment. The President is under substantial pressure fro m political operati ves within the
White House and his political allies in Congress to implement this policy.

The President’s father who holds a BA degree in economics has expressed s k epticism about the
efficacy of temporary tax cuts as a d evice to e ncourage aggregate consumption spending. In
particular, the President’s father believes that a substantial increase in aggregate consumption due
to temporary tax cuts is inconsistent with the predictions of the Permanent Income Hypothesis
(PIH ) . The President has never heard of the PIH and wou ld like to understand exactly what it is
and wants to be aware of its implications for the policy in i tiative he is considering.

Proponents of the temporary tax cut argue that the assumptions underlying the PIH are such that
it is does not accurately describe consumption behavior and as such, it should not be used to
guide policy. The president is wary of basing policy decisions on a theory (i.e. the PIH) that may
not be very applicable in the real world . In ligh t of the President’s concerns he calls you into the
Oval Office and asks you to prepare a memo explaining the economic rationale und erlying both
sides of the issue. Keeping in mind that the president has no formal training in economics, prepare
a refined draft o f the memo you would present to the president. Your memo should be
professionally presented and should not exceed two ( 2) double- spaced typed pages of text, and a
separate page of references.

An effective memo should address the following issues. (However, I am not saying that these
are the only issues that an effective memo should address.)

(a) Briefly but thoroughly describe/explain the Permanent Income Hypothesis. This shou l d
include a clear definition of permanent income, an articulation of how consumption in any
given period is determined under the PI H , a clear explanation of the PI H ’s predictions for
the effects of permanent and temporary changes in income on current aggregate
consumption.

(b) Since some of the President’s advisors believe that the PIH does not do a good job of
explaining real world behavior and that temporary tax cuts will be effective, your memo
should articulate the conditions under which temporary tax cuts will have large effects on
aggregate consumption. In particular, your memo should inform the president about the
assumptions underlying the PIH and should explain how departures from the a s sumptions
underlying the PIH that are likely to allow temporary tax cuts to have important effects on
aggregate consumption.

( c ) Since the PIH is a theory, you expect the President to ask for evidence on the consistency of
the PIH’s predictions with the empirical facts. Therefore you should do whatever research
is needed to find evidence on the PI H . For example, are there historical examples in which
households experie nced temporary changes in income? What was the estimated MPC out
of these changes in income?

You are required to referen ce whatever literature you rely upon in writing your paper. In
assessing the quality of your paper, I will pay particular attention to:

(a) the extent to which your paper demonstrates that you have developed a thorough
understanding of the underlying economics
(b) the thoroughness and accuracy of your ana lysis
(c) the thorough ness and quality of your research
(d) the cl a rity and quality of your writing

You are required to submit your paper to me as a pdf file via e – mail. You should name your pdf
file lastname202HP.pdf where lastname is your last name. Please note that I will not accept hard
copies. Your papers are due by 11:59 p.m. on Tues day, June 23, 2015. This assignment is worth
25 points and is mandatory. If you do not turn in a paper, I will not assign a course grade until you
do. In addition, make every effort to submit your papers on time. I will deduct 5 points out of 25
for each day a paper is late.

Finally, a cautionary note. University rules prohibiting plagiarism will be vigorously enforced. If
you have any doubt or questi ons about what constitutes plagiarism, I suggest that you visit the
following website: https://www.muohio.edu/integrity/student – resources.html . It is your
responsibility to avoid pla giarism. I will not accept claims of ignorance as a defense.

Example of in – text citation without quotes

Diamond (1996) argues that …..

Example of in – text citation involving quotes

Diamond (1996 pp. 53) observes that “financial intermediaries are ….”

List articles cited using the following format

Diamond, Douglas, W.; “Financial Intermediation as Delegated Monitoring: A Simple Example”
Economic Quarterly 82 (Summer 1996): pp. 51 -66, Federal Reserve Bank of Richmond.

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