Question

11. Demonstrate the tax increase using the closed AD-AS model, ceteris paribus, after the initial short-run shock (i.e., decrease in wealth), but before the nominal wages and prices are fully flexible. [Note: this is the counterfactual version.]

[Sub-questions 11-12 are connected.]

After the tax increase, _______ shifts_______.

A. the aggregate demand curve; leftward

B. the aggregate demand curve; rightward

C. the short-run aggregate supply curve; leftward

D. the short-run aggregate supply curve; rightward

E. the long-run aggregate supply curve; leftward

F. the long-run aggregate supply curve; rightward

G. both the short-run aggregate supply curve and long-run aggregate supply curve; leftward

H. both the short-run aggregate supply curve and long-run

12. The resulting equilibrium results in a _______ price level, a _______ real GDP, indicating a _______.

A. lower; lower; worsening recessionary gap

B. lower; higher; worsening inflationary gap

C. higher; lower; improved recessionary gap

D. higher; higher; improved inflationary gap

E. lower; lower; return to long-run equilibrium

F. lower; higher; return to long-run equilibrium

G. higher; lower; return to long-run equilibrium

H. higher; higher; return to long-run equilibrium

Answer 1

Economy begins at E at its long run equilibrium level. A decrease in wealth is a demand shock that shifts the AD down. Prices are sticky in the short run so SRAS is upward sloping. Economy moves to F where output is reduced resulting in a recessionary gap and the price level also declines. Now there is a tax increase which reduces disposable income and consumption. AD further shifts to the left and real GDP and price level both decline at G.

11) Option A

12) Option A