Question

Consider the IS-LM and aggregate demand/aggregate supply model of Chapters 11 and 12. Consider a reduction in the level of taxes, starting from an initial situation in which output is equal to its natural level.

a) Depict the short-run effects of the reduction in T using 3 graphs: one for the market for goods and services, one for the IS-LM curves, and one for the Aggregate Demand and Supply curves. How do the new short-run equilibrium values of r, Y and P compare to the initial ones? (i.e., are they higher, lower or equal?)

b) Depict the transition from the short-run to the long run. To do this, draw 3 new graphs (with the same variables as before), in which the initial situation is the short-run equilibrium after the decrease in T. How do the long-run equilibrium values of r, Y and P after the shock in T compare to ones before that shock?

Note: be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift (including the initial adverse shock); and v. the terminal equilibrium values.

Answer 1

a) From long term equilibrium value, there is a reduction in taxes. Which means the consumption part of aggegate demand will increase. The 3 graphs are shown below:

Graph for goods and services:

IS-LM:

AS-AD graph:

From the above graphs, we can see that due to reduction in taxes, consumption increases. Output increases above it's natural level, interest rate and prices also rises from initial levels.

b) Due to overheating of economy, prices have risen more than natural level, in the long run, consumption might fall fue to inflation. It would also affect net exports as exports might fall due to high prices. Further, inceased inteerst rate can bring down investment level, due to high cost of borrowing. So, in the long run, AD curve will come back to it's original position, that is, the level before reduction in taxes.

Graph for goods and services

IS-LM

AS-AD

Transition to long term= Due to high price and inteerst rate, net exports and investment will fall, while due to reduction in taxes, consumption has increased. So, in the long run, all the variables will come back to their natural levels, however, share of components of aggregate demand will have changed