Question

Assume a developed nation’s economy is in a long run equilibrium and shows signs of slow, steady growth. In addition to that, here are a few other facts and assumptions you should keep in mind: 1) Its currency has appreciated slightly over the last 6 months against all major currencies; 2) This nation recently abandoned all of its trade agreements with no word on if or when they might be renegotiated; 3) The central bank pushed the overnight bank-to-bank lending rate from 0% to 1% to 1 ½ % over the last 6 months; 4) The population is educated but lagging behind many other developed nations; 5) Consumer confidence is strong in some regions, weak in others; 6) Its monetary policy is sound.

Fiscal policymakers plan to enact a significant tax cut. Given this nation’s current status, what impact will the tax cut have on this nation’s economy in the short run and long run? Use the AD/AS framework (but do not draw a graph) in your answer.

Answer 1

A significant tax cut will increase the domestic demand for products in the economy thereby causing the demand curve to shift to the right. Even on the supply side, a reduction in production-related taxes will lead to increase in the supply of products and thus cause the supply curve to shift to the right. This cause the total production in the economy to increase in the short run with pretty stable price levels.

In the long run, the tax cut might not have any significant impact on the economy. This is because once the taxes have been reduced, the general public will get used to these reduced taxes and it will not necessarily lead to increase in consumption levels. Besides this, since the country does not trade its products with the foreign countries, it will not be able to increase the demand for its products by exporting. Thus in the long run, both demand and supply curve will shift back to the left, thereby causing the total output equal the normal level of output.