Question

For this question, using the AS-AD diagram and assume that the economy is initially operating at the natural level of output. An increase in taxes will cause which of the following?

A) a reduction in output and no change in the aggregate price level in the short run

B) a reduction in employment and no change in the nominal wage in the short run

C) an increase in investment in the medium run

D) an increase in the aggregate price level, no change in output and no change in the interest rate in the medium run

Answer 1

The correct answer is (C)

Contractionary Fiscal policy like increase in taxes may affect investment in the medium run, because affects the interest rate in the medium run. The rise in taxes causes the IS Curve to shift to the left, from IS0 to IS1. On the AS-AD diagram, there is fall in the AD and therefore, the AD Curve shifts to the left, from AD0 to AD1. The new equilibrium has a lower output level, Y1, and also a lower price level, P1. This lower price level raises the real money supply (M/P) and shifts the LM Curve downwards, from LM0 to LM1. The new short run equilibrium is at A1, with lower output level Y1, lower price level P1 and an lower interest rate of i1.

In the medium run, the price level has fallen below the expected price level, Pe , and so the expected price level falls too pushing the price level down further, which in turn pushes up the real money supply (M/P) shifting the LM Curve further down, to LM2. The level of output increases back to the natural level of output, Yn, and the interest rate falls further to i2. The fall in the price level shifts the AS Curve downwards, giving the medium run equilibrium at A2, with output at the natural level (Yn) and the price level falling to P2. Overall, output is back to its natural level and the price level is lower. But the interest rate is also lower in the medium run and therefore, investment increases in the medium run which compensates for the fall in output due to increase in taxes.