Question

1. Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following government policies will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output?

1. There is an increase in taxes on households.
2. There is an increase in the quantity of money.
3. There is an increase in government spending.

Answer 1

a) An increase in taxes will redues disposable income with consumer which tends to reduce aggregate demand in the economy. It will shift the AD curve tos its left from AD to AD1 in short run which reduce price from P to P1 and output reduce from Y to Y1.

  

Fall in demand curve will induce producers to reduce their production to avoid inventories which will reduce the aggregate supply in the economy and shift AS curve to its left from AS to AS1 which will raise the price to its initial level while output level fall further.

b) Increase in quantity of money will raise cash people hold with them which tends to raise aggregate demand in the economy in short run which shift demand curve to its right from AD to AD1. It will result in rise in price from P to P1 and output to rise from Y to Y1.

Rise in quantity of money available in the system will reduce rate of interest which induce producers to invest more money in the economy which will raise aggregate supply in long run and shift supply curve to its right from AS to AS1. It will reduce the price again to its initial level and raise its output level.

c) A rise in government spending will raise aggregate demand in the economy and shifts aggregate demand curve to its right from AD to AD1 which raise price level from P to P1 and output from Y to Y1.

At this high demand, producers will try to raise their aggregate supply to earn profit at higher price which will shift aggregate supply curve to its right from S to S1 which will reduce price to its initial level while raise output level further.