In: Economics
Ans. When government increases
personal income tax, households' disposable income falls. So, there
consumption falls leading to fall in aggregate demand for goods and
services shifting the aggregate demand curve rightwards from AD to
AD". So, this leads to decrease in transaction demand for money
leading to a fall in interest rate. This fall in interest rate
partially offsets the decrease in aggregate demand for goods and
services because a fall in interest rate decreases cost of
borrowing inducing investment spending. This shifts the aggregate
demand curve rightwards from AD" to AD'. But the net effect still
is decrease in aggregate demand, so, at given aggregate supply it
leads to a surplus of goods and services in the market decreasing
tge price level from P to P' which reduces quantity supplied moving
the equilibrium output to a decreased level Y' from Y.
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