Question

AS-AD model:

Which one is the correct? and WHY? Could you please explain it to me graphically (Which curves shift (AS/AD...) etc.) TIA

When gov. reduces deficits by increasing taxes...

1. in the short run, output decreases, and in the medium run, output Returns to potential
2. in the short run, Government expenditures increase and thus in the medium run, output increases
3. in the short run, interest rate is higher, and in the medium run, the effect of consolidation Policy on Investment is not clear
4. in the short run, IS curve shifts inward to the left and in the medium run, it shifts back to its original Position due to increase in investment

Answer 1

Correct option is (1).

Increase in tax will decrease disposable income, which will decrease consumption and decrease aggregate demand which will shift AD curve leftward, lowering price level and lowering real GDP in short run. In long run, lower price level will decrease input costs, making firms increase production and increasing aggregate supply. Short run aggregate supply curve will shift rightward, further decreasing price level and restoring real GDP to original level.

In following graph, initial equilibrium is at point A where AD0 (initial aggregate demand), SRAS0 (initial short-run aggregate supply) and LRAS0 (long run aggregate supply) curves intersect, with initial equilibrium price level P0 and real GDP (= potential GDP) Y0. When AD falls in short run, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P1 and restoring real GDP to potential GDP of Y0.