Question

1.    We want to study how lower taxes will affect GDP and the price level if the economy starts out with cyclical unemployment. For each question, mark clearly the axis, the curves, and the equilibria.

(i)            Draw the aggregate demand curve and the short and long run supply curves for a country in one diagram. Assume that the country starts out in a situation with cyclical unemployment.

(ii)           What is the problem with the current situation?

(iii)          Assume that the government decides on a fiscal policy plan of reducing taxes to households. Illustrate in your diagram the effect on the economy of lower taxes by shifting the curve(s). Mark the new short-run equilibrium after lower taxes P2, Y2.

(iv)          How will the long-run equilibrium differ from the short-run equilibrium? (if it does) Explain briefly.

What was the effect of the reduction in taxes on output and the price level in the short and the long run?

Answer 1

(i) In following graph, AD1, SRAS1 and LRAS1 are the initial aggregate demand, short run aggregate supply curve and long run aggregate supply curves intersecting at point A with price level P1 and output Y1. Since there is cyclical unemployment, it means economy is in recession and AD1 intersects SRAS1 to the left of LRAS1.

(ii) The problem is that price level is lower than at full-employment level, casing deflation, and output is lower than potential output, causing a recessionary gap.

(iii) Lower tax will increase disposable income, increasing consumption demand and aggregate demand, shifting AD1 rightward to AD2. Assuming economy does not reach long run equilibrium yet, the new short run equilibrium is at point B where AD2 intersects SRAS1 with higher price level P2 and higher output Y2 (though recessionary gap still exists).

(iv) Long run equilibrium is established when AD shifts rightward enough to AD3, as to intersect SRAS1 and LRAS1 at point C with still higher price level P3 and output Y3 which equals potential output, so the recessionary gap is completely eliminated.

Effect of tax in short run is to raise price level and output, but some recessionary gap still existed. In the long run, price level and output are even higher and correspond to the full employment level, so no recessionary gap exists anymore.