Question

Use the AD/AS model to explain how a tax cut without a government spending decrease affects the economy in the short run and adjustment back to the steady state.

Answer 1

When a govt indulges in a fiscal policy like tax cut , this causes an increase in the aggregate demand in the economy. This increase in aggregate demand is a result of increase in capacity of individuals , which is because now people have to give up a lower amount of their income as tax hence tax rate reduction increases aggregate demand , shifted from the access capacity. Hence AD1- AD2 , as a result of expansionary fiscal policy.

with an increasing aggregate demand from point A to B, the quantity of output or the GDP in the Economy rises , as demand rises. This rising demand also causes the price to rise. ( P1- P2).

Long run Adjustment:

Once all the adjustments are made in the Economy with capacity being fully utilised, the rising price in the Economy causes the shortage in the aggregate supply. This falling aggregate supply further causes the price to rise , which producers extract in order to recover from the lossing market. This causes the GDP to contract back to the original level but price level being higher. This is the point. C on the diagram , which is in equilibrium with the long run aggregate supply curve with Y1 GDP or output level. This is the steady state.