Question

The policy proposals listed below come from President Trump’s FY2018 proposed budget.[1] For each of the proposals, do the following:

-Determine whether the policy affects AD or AS, and what the effect of the proposal will be on the price level and aggregate output.

-Graphically demonstrate the short-run effect of the policy on the price level and aggregate output using AD/AS analysis.

-Be sure to analyze each effect independently.

Policy Proposals:

a. Lower individual income taxes.

b. Reduce non-defense discretionary spending each year.

c. Decrease regulations on business firms.

d. Invest $2.6 billion in border security infrastructure and technology.

Answer 1

In each graph, AD0 and SRAS0 are initial AD and short run AS curves intersecting at point A with initial long rn equilibrium price level P0 and real GDP Y0.

(a) AD curve will shift right.

Lower individual income tax will raise consumption spending, increasing aggregate demand and shifting AD curve toward right, increasing both price level and real GDP. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(b) AD curve will shift left.

Lower discretionary spending meanings that government purchases will decrease. Lower government purchase will decrease aggregate demand, shifting AD curve leftward. In short run, this will decrease both price level and real GDP. In following graph, as AD decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

(c) AS curve will shift right.

Lower regulation on firms will make it easier for firms to conduct business, so firms will increase output. This will increase short run aggregate supply, lowering price level and increasing output. In following graph, SRAS curve shifts right to SRAS1, intersecting AD0 at point B, decreasing price level to P1 and increasing real GDP to Y1.

(d) AD curve will shift right.

Higher infrastructure spending will raise government spending, increasing aggregate demand and shifting AD curve toward right, increasing both price level and real GDP. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1.