Question

drawing the graph of AD (Aggregate Demand), SRAS (Short- run aggregate supply curve) and LRAS ( long run aggregate supply curve) and writing down what would happen under the two conditions "increase personal income taxes" and "decrease personal income taxes".

You need to write down everything happens by following the seven steps:

1. What would happen under the condition? (Whether AD, SRAS, or LRAS would change? And in which direction the curve would shift?)

2. Where is the new short-run equilibrium? (You need to mark the point in the graph.)

3. What changed in the new short-run equilibrium? (Price level/real GDP goes up/down when comparing with the initial equilibrium)

4. Is the short-run equilibrium under-producing or over-producing? What would happen in the labor market?

5. What would happen next? (Whether AD, SRAS, or LRAS would change? And in which direction the curve would shift?)

6. Where is the new long-run equilibrium? (You need to mark the point in the graph.)

7. What changed in the new long-run equilibrium? (Price level/real GDP goes up/down when comparing with the initial equilibrium)

Answer 1

In following graphs, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (which is equal to potential GDP) Y0.

(1) Increase in personal income taxes

Higher personal income tax will decrease disposable income, so consumption demand will fall. A decrease in consumption will decrease aggregate demand. AD curve will shift to left, reducing both price level and real GDP, giving rise to a recessionary gap in short run. Lower real GDP will increase unemployment rate in labor market.

In the long run, lower price level will reduce wages and prices of inputs, decreasing firms' production costs. Firms will increase output, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP level, wiping out the short-run recessionary gap. Unemployment rate will restore at natural (full-employment) rate.

In following graph, when aggregate demand falls, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1). In the long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0, removing the short-run recessionary gap.

(2) Decrease in personal income taxes

Lower personal income tax will increase disposable income, so consumption demand will rise. An increase in consumption will increase aggregate demand. AD curve will shift to right, increasing both price level and real GDP, giving rise to an inflationary gap in short run. Higher real GDP will decrease unemployment rate in labor market.

In the long run, higher price level will increase wages and prices of inputs, increasing firms' production costs. Firms will decrease output, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring real GDP to potential GDP level, wiping out the short-run inflationary gap. Unemployment rate will restore at natural (full-employment) rate.

In following graph, when aggregate demand rises, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real output Y1, with short run inflationary gap of (Y0 - Y1). In the long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, removing the short-run inflationary gap.