Question

According to the IS-MP-AD-IA model. In December 2017, the U.S. President and Congress passed a substantial decrease in taxes. Assume that the U.S. economy starts out at potential output at the end of 2017.

a) According to the IS-MP-AD-IA model, what should happen to output and inflation over time? Draw a diagram to help explain your answer.

b) If the tax cuts are permanent, what would be the long-run effect of the tax cut in the ADIA and IS-MP diagrams? Draw those diagrams to explain your answer.

c) What would be the long-run effect of the shock on output, inflation, and the real interest rate? What would be the long-run effect on consumption, investment, and government purchases? Briefly explain why.

Answer 1

The components of aggregate demand (AD) are as follows: AD= C+I+G+NX where C: Consumption, I: Investment, G: Government Spending and NX: Net Exports. If the economy starts of at potential output, then it were originally at point A in Fig 1. When the President and Congress pass a substantial tax decrease, the disposable income of the consumers rises. This expansionary fiscal policy raises AD and the AD curve shifts rightward from AD to AD’. Consequently, the price level (inflation) rises from P to P’ and GDP (output) rises from Y to Y’.

a) The effects of this policy are very closely linked to output and inflation. The AD-IA model takes into account changing interest rates with respect to changes in the rate of inflation. The IS-MP model reflects the short run fluctuations in interest rate, inflation and output.

The AD-IA curve as shown in Fig 2 has a rightward shift of the AD curve from AD to AD’. This implies that the economy starts operating above potential. As inflation increases (as shown in Fig 1), the Inflation-Adjustment (IA) line shifts upwards which causes a movement along AD’ unless real GDP becomes equal to potential GDP. Similarly, on the IS-MP graph shown in Fig 3, The MP curve is upward rising and IS curve is downward sloping with real interest rate on the vertical axis. When the tax rate are cut, the IS curve shifts rightward from IS to IS’ as a result of expansionary fiscal policy. With inflation in the economy, the MP curve shifts upward. Thus, the real interest rate and the output both rise from r to r’ and Y to Y’ respectively.

b) In the short run, as depicted above, the IA curve is horizontal because adjustments to the preset inflation is not appropriately made in the short run. However, the long run effects imply that the IA curve will go on shifting upwards, until it intersects the AD’ and LRAS curves to operate at potential output again. Thus, the diagram of AD-AI model for short run and long run are the same. However, the short run effect of a tax cut is shift as a movement from point A to B (in figure 2) and that in the long run is seen as the shift from point A to C (Fig 2). On the other hand, as inflation continues to rise, the MP curve will continue to shift upwards (MP’ to MP’’) till it intersects the IS’ curve. At that point, the long run effect will restore the economy’s operation at the level of potential output (Y) with a significant rise in interest rate (r’ to r’’). Therefore, the shirt run effect is one with shift of MP from MP to MP’ and the long run effect is one with shift of MP to MP”.

c) In the long run, therefore, the output will move back to potential level of output (Y) as opposed to operating above the potential level in the short run. Inflation will be at a higher level (Fig 2) as price level rises in the long run. The real interest rate will also be at higher level (Fig 3).

In the long run, with a persistent rise in inflation, consumption rises.

As real interest rate rises, the cost of borrowing goes on increasing which reduces investment demand in the long run, therefore investment falls. Similarly, the cost of borrowing for Government will also rise with increase in real interest rate and thus government purchases will fall.