Question

Suppose Congress votes to decrease corporate income tax rates. Use the AD/AS model to analyze the likely impact of the tax cuts on the macroeconomy. Show graphically and explain your reasoning. What exactly causes AD and/or AS to shift? What happens to GDP and the aggregate price level? Why?

Answer 1

Assuming that the economy is initially at the equilibrium point of e₀, with P₀ price level and y₀ output. Now, if the Congress votes to decrease corporate income tax rates, then the Aggregate Demand (AD) curve will shift from AD to A₁D₁.

The decrease in corporate income tax rates increases the funds available to the firms for investment, as a result the tax cut would lead to increase in investment demand which causes the AD curve to shift. At the initial price level of P₀, the output demanded would increase to y₂, while the economy can supply only y₀. So, this will cause the price level in the economy to rise.

As, the price level rises in the economy, the real money balances decline. This will cause people to withdraw some of their speculative balances to finance their transaction needs. As a result, interest rates will rise to keep the money market in equilibrium. The rise in interest rates would cause investment demand to decline. So, the economy would start to move towards the new equilibrium point of e₁, as shown in the diagram.

On, the other side increase in the price level from P₀ to P₁ will result in increase in the aggregate supply, causing the economy to move to point e₁.

So, the decrease in corporate tax rates would result in higher price level in the economy (P₁) and higher output (y₁) in the economy.