105 Suppose that the real interest rate in an economy is 6 R

(10.5) Suppose that the real interest rate in an economy is 6%. Real GDP grows by 2.75% a year. The new chief economic adviser to the government argues that a tax increase of $20 billion will generate huge benets because the real interest rate is much larger than the

growth of GDP, so that tax rates will be lower on future generations forever. What is wrong with this argument?

Solution

The given argument is wrong because it justifies a large tax increase with high interest rate in the economy.

Instead, it should argue that such a high interest rate will create a burden on the consumers who would respond by reducing consumption demand which in turn will reduce GDP and harm the economy.