Question

Recently, the administration and the Congress implemented a large tax cut for firms and households. How do you describe this policy? Using an Aggregate-Demand/Aggregate-Supply graph, demonstrate the impact of these tax cuts on the economy.

Answer 1

A tax cut is an expansionary fiscal policy, aimed at boosting aggregate demand.

A decrease in personal tax will increase disposable income, raising consumption demand and a cut in business tax will boost investment demand, therefore increasing aggregate demand (AD), shifting AD curve toward right which will increase price level, income and real GDP in the short run, thereby giving rise to a short run inflationary gap. In the long run, higher price level will increase the cost of inputs and firms will decrease their output, lowering aggregate supply. This will shift the short-run aggregate supply curve toward left and new long run equilibrium will be at a further higher price level, but restoring real GDP to potential GDP level, thereby eliminating the inflationary gap.

In the graph, initial long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (= full-employment/potential GDP) Y0. Higher consumption and investment demand will increase aggregate demand, shifting AD curve toward right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, giving rise to a short-run inflationary gap of (Y1 - Y0). In the long run, SRAS0 curve shifts toward left to SRAS1, intersecting AD1 at point C with further higher price level P2 and real GDP will be restored to potential GDP level of Y0, eliminating the short run inflationary gap.