Question

describe the correct sequence of events that occurs when the government of a nation that was originally in equilibrium raises its personal income tax rates. Be sure to mention which curve (AD or SRAS) shifts, which way that curve shifts and the impact that it would have on the nation's price level and Real GDP.

Answer 1

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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