Question

Instructions: Answer each of the following questions:

Question: Use the AD-AS model to analyze the effects of each of the following events on equilibrium Y and P in the short-run and in the long-run:

1. The government announces a 1% decrease of VAT (Value-added Tax)

2. There are new advances in technology that allows for more efficient production of oil

Answer 1

A. VAT is paid by the producer along the production chain. The introduction of a 1% decrease in VAT reduces the effective production costs leading to increase in production. This leads to a rightward shift of the aggregate supply curve increasing equilibrium output and decreasing equilibrium price. See figure below. This is the short run scenerio.

B. The advances in technology that reduce the cost of oil production will reduce the cost of inputs (since oil is a major input in production of many goods). This will reduce the overall cost of production leading to increase in total supply, shifting the supply curve towards the right. This reduces the price from P1 to P2 and increases output from Y1 to Y2. (again refer to the same figure as in A). Again this is the short run scenario.

In the long run , the aggregate demand also increases in response to price reduction, shifting the demand curve towards the right . This further increases output and prices, shifting the long run supply curve to a higher level of output. Shown in figure below (both A and B).