A country enacts a permanent investment tax credit that reduces the after-tax cost of purchasing new machinery for firms. The policy is intended to raise long-run output rather than stabilize the business cycle. Based on the policy described, which long-run effect is most likely?
- The capital stock increases over time, raising labor productivity and shifting LRAS to the right. (correct answer)
- The capital stock increases over time because higher nominal GDP automatically creates more real machines.
- The capital stock increases over time because aggregate demand permanently exceeds aggregate supply.
- The capital stock is unchanged because tax credits affect spending but not incentives to invest.
- The capital stock is unchanged because real GDP can rise only if the price level rises.
Explanation: Economic growth is a sustained rise in real GDP per capita, fueled by increases in the capital stock that enhance productivity and potential output. Productivity improves as more capital per worker allows greater output, expanding the economy's long-run capacity. The investment tax credit lowers machinery costs, encouraging capital accumulation that boosts productivity and shifts LRAS rightward. A misconception, evident in choice C, is that demand exceeding supply can permanently grow the capital stock, but growth requires real investment incentives. Policies promoting capital formation, such as tax credits, serve as a transferable strategy to shift the LRAS curve or PPC outward for enduring economic expansion.