Question

Using the IS-LM and Aggregate Supply-Aggregate Demand (AS-AD) models of Chapter 12 with a flat short-run AS curve (that is, completely sticky prices), suppose the economy is at the natural rate of unemployment and so, at long-run equilibrium. Suddenly, taxes are reduced with no change in government spending. Tell me (or show on a graph) what happens to the IS and/or LM curves. Show on a different graph what happens on the AS-AD diagram in the short-run (drawing in the long and short-run aggregate supply curves and the aggregate demand curve, and shifting one or more curves). Due to what happened above there will either be a shortage or surplus of labor and goods, so prices will either fall or rise as we move to the long run. Tell me (or show in a graph), what happens to the IS and/or LM curves as prices change and we move to the long-run. Explain why the curve(s) shifted as they did.

FIGURE 12-8 Interest rate, i Expected Deflation in the IS-LM Model An expected deflation (a negative value of ET) raises the real interest rate for any given nominal interest rate, and this depresses investment spending. The reduction in investment shifts the IS curve downward. Income falls from Y, to Y. The nominal interest rate falls from i, to iz, and the real interest rate rises from r, to r2. IS, Y Y ,Income, output, Y

Answer 1

we know that, initially economy is at its long mun equilibulum i-e. producing natural output. Reducing taxes, with no change we government spending will provide extua spending power to economic entities. This will increase consumption this will kwithur increase apsulegate demand. a.) IS-LM cweres CM 72 777 Shout mun impact -> interest rates incuense → output has a tendency to inLHERAL beyond natural • output Yn y output As taxes are reduced is cwere shifts to is, from I so. - As cwere is flat in the shout run indicating that there is unemployment at lower levels of a output. Himms can increase their pucduction by obtaining as much labou as they want to the werent wages. But beyond long seun equilibrium there is shoutage of labou and wages go up with every adolitioval tiring, This will incue ase average cost of production for the firms & there fare puices will also go up Pelice 1 Nole: Pollase Rising short een impact in puice in sloer -> Labar shantage otwy wibe output I causes puices to" increase to Yu -) output goes above Youtput natural output 7 uurt vs Parnal preu hal Po flat AS A D. would have returned

ina LM, (M/2) izl.- LMO(9) » фир Yny ds puices incuease due to labou shoutage beyond yn Meal money supply falls Given nominal money supply, a this causes im ewere to shift upward slightly in shout mun. As puices further increase in the long run with complete adjustment un stickiness, LM were fwitter shifts up to LM2. This process continues till output a returns to natural level of output (Yn). In long suu, interest rates have incuessed significantly causing investment to fall. Entire initial increase in consumption due to tax cut how been compen- sated by fall in to investment and output comes back to Yu.