Question

3. Problems and Applications Q3 The problem of time inconsistency applies to fiscal policy as well as to monetary policy. Suppose the government announced a reduction in taxes on income from capital investments, such as new factories. If investors believed that capital taxes would remain low, the government's action would lead to a level of investment. After investors have responded to the announced tax reduction, the government an incentive to renege on its policy. True or False: Given your answer to the preceding part, investors would not believe the government's announcement. True False

Answer 1

Answer:

If investors believed that capital taxes would remain low, the government's action would lead to an increased level of investment.

After investors have responded to the announced tax reduction, the government have an incentive to renege on its policy. True

Given your answer to the preceding part, investors would not believe the government's announcement. True

Explanation:

It has been established that there are about six months lags between when government's monetary and fiscal policies change and when they are reflected in the marketplace.  This is why some have argued that rules should govern government monetary and fiscal policies instead of allowing discretion to be used.  With rules, reneging on policies become more difficult as the government can be challenged for breaking its own rules.