Question

Let the economy of a country named, Happy Land be in a long-run equilibrium position. Using a diagram, explain how each of the following affects equilibrium real GDP and price level in the short-run, as well as in the long-run:

A) An increase in income tax rate

B) An decrease in exchange rate

C) A significant increase in foreign income caused by an economic boom in the rest of the world

D) A decrease in nominal money supply

Answer 1

a. Increase in the tax rate would cause the AD curve to shift inwards to the left because higher tax rate would discourage consumption as the disposable income would reduce. There would be a recessionary gap in the economy, with fall in price and GDP. This would reduce the wages of the workers, which would incentivise the firms to hire more workers. As they hire more,the supply curve would shift out to the right and the long run equilibrium is restored at the same level of GDP but at a lower price.

b. A fall in exchange rate would encourage the exports and shift the AD curve to the right. The exports would become more competitive in the world market. There would be a situation of inflationary gap with higher price and GDP. Higher price would compell the workers to negotiate for higher wages, which would reduce the supply and the supply curve would shift inwards to the left until the long run equilibrium is restored, at the same level of GDP but at a higher price.

c. Increase in foreign income would increase the domestic country's export. This would shift the AD curve to the right, with higher prices and GDP. There would be a situation of inflationary gap in the economy. Workers would want to re-negotiate their work contracts and demand for higher wages which reduces the supply and the supply curves shifts inwards to the left and the new long run equilibrium is restored at the same level of GDP but at higher prices.

d. As the supply of money decreases, less money is available in the market, the AD curve shifts inwards to the left. There is a situation of recessionary gap in the economy, with lower wages and GDP. Lower wages in the economy would encourage the firms to hire more workers and thus the supply curve would shift out to the right, the long run equilibrium is restored at the lower price level and the same level of GDP.