Question

Illustrate a graph with aggregate demand, short-run aggregate supply and long-run aggregate supply all intersecting. Then, show what happens in the short-run when the government increases taxes. What happens to the price level and output in the short-run? Finally, adjust the short-run aggregate supply curve so that we are back in long-run equilibrium. What is the long-run effect of the increased taxation on output and the price level? Be sure to include your illustrations.

Answer 1

An increase in tax rate by the government will reduce disposable income of the consumers. A reduction in disposable income will reduce consumption expenditure in the economy which reduces aggregate expenditure in the economy and this reduces aggregate demand in the economy. In the diagram below, initial equilibrium occurs at point E1. A decrease in aggregate demand will shift the AD curve leftwards to AD' and at new short run equilibrium point E2, both price level and output has decreased in the short run which causes recessionary gap in the economy. This can be depicted as:

This causes recessionary gap in the economy in the short run. Unemployment rate increases and this increases bargianing power of employers and thus reduces wage rate which reduces cost of production in the economy and shifts the SRAS curve rightwards to SRAS' and new long run equilibrium is established at point E3 where prices have decreased to OP3 and output is back to the full employment level.

Thus, in long run increased taxes reduces price level and keeps output constant at full employment level.