wages fixed, labour is laid off, which decreases supply and puts upward pressure on prices. The
reverse of the argument would be true when the CPI decreases; this is confirmed in Table 8 as well.
5.5 Long-run effects
The final set of simulations to be discussed is the effects of tax or price increases in the long-run.
The long-run is characterised by a flexible capital stock, endogenous domestic demand, and an
exogenous balance of trade. The results of three simulations are presented in Table 9. The last
and third last rows contain zeros to indicate the assumptions of given world prices and exogenous
employment growth respectively. The three columns to the right (copied from Table 8) are the
short-run equivalent scenarios of the three long-run scenarios to the left of Table 9.
INSERT TABLE 9 HERE
Once again the results are interesting, and they confirm some of the short-run conclusions outlined
above. The highest increases in CPI would be experienced when a tax is levied on households only,
while an increase in the administered price would have a smaller effect than a tax on intermediate
and household consumption. In the majority of scenarios depicted in Table 9, we see increases in
CPI together with decreases in GDP. In a simple supply and demand diagram, this would only be
possible if supply shifts to the left and demand does not change enough to offset the fall in supply
- positive or negative.
In the long-run, real wages are flexible, as well as household consumption, so that we only need
to explain three pairs of comparisons: (i) why we do have increases in CPI in the long-run, while
similar assumptions in the short-run lead to lower prices; (ii) why a tax on only households leads
to larger increases in CPI, and (ii) why using an administered price leads to lower increases in CPI
than a tax.
Firstly, the values for CPI are higher in the left three columns than for the similar short-run
situations on the right. Our assumptions about the macroeconomic variables on the demand side
mainly drive the results. In the short run, the changeable variables are consumption expenditure
and the trade balance, while in the long-run, the trade balance is fixed, and C, I and G are allowed to
change. Investment decreases as firms demand less capital in the long-run. Government consumption
moves with household consumption by assumption (the percentage changes are the same in Table 9);
the movement is one that decreases, due to the rise in commodity prices. In both the short-run and
the long-run, GDP decreases due to a decrease in employment of labour. Total demand must follow,
and in the short-run, there is a large decrease in household consumption, the only component of
Gross National Product (GNP) that can change and which has an influence on the CPI. In the long-
run, all three components of GNP can change, so that we find much smaller decreases in demand
by households, and less downward pressure on CPI. In terms of our virtual graph of supply and
demand, household demand changes less in the long-run, and has a smaller offsetting effect on the
increase in prices that are experienced due to a fall in supply.
Secondly, the increase in CPI is higher in both the long- and short-run if only households are
taxed, given that household consumption and real wages are also flexible. A tax on firms increases
their costs and forces them to employ less labour than before. They employ less capital and decrease
production. From Table 9, it is clear that GDP decreases when firms are included in the tax, while
it almost does not change when only households are taxed. This results in a large decrease in total
demand in the long-run, with downward pressure on prices. Moreover, if we look at the fourth row in
Table 9, we see that exports differ markedly between the two scenarios. When firms are included in
the tax on electricity, they increase the prices of their goods (actually the market does, since prices
are determined by marginal cost in the model), including the prices of exported goods. The result
is that export demand also falls to strengthen the demand effect. If only households pay more for
electricity, a decrease in demand leads to lower prices of some commodities, which stimulates export
demand to counteract the falling demand effect of the tax, and hence counteracts the decrease in
CPI as well.