Question

III. Suppose the economy begins with output equal to its natural level. Then, there is a reduction in income taxes.

a. Using the AS-AD model, show the effects of a reduction in income taxes on the position of the AD, AS, IS, and LM curves in the short- and medium-run.

b. What happens to output, the interest rate, and the price level in the medium run? What happens to consumption and investment in the medium run?

Answer 1

(a)

Lower income tax will increase disposable income and consumption. This will shift IS curve rightward in short run, increasing interest rate and output. In medium run, higher interest rate will increase price level, which will increase the demand for money, thereby shifting the LM curve to left until it intersects new IS curve at further higher interest rate but original level of output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. Lower income tax shifts IS0 rightward to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1 in short run. In medium run, LM0 shifts left to LM1, intersecting IS1 at point C with further higher interest rate r2 and original output Y0.

Also, higher consumption demand will increase in aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, giving rise to an inflationary gap in short run. In medium run, higher price level increases production cost so firms reduce production, lowering aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating the short-run inflationary gap.

In following graph, initial equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial equilibrium price level P0 and initial equilibrium real GDP (= Potential GDP) Y0. When aggregate demand rises, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with inflationary gap of (Y1 - Y0) in short run. In medium run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating short run inflationary gap.

(b)

In medium run,

(i) Output remains unchanged at original level.

(ii) Interest rate is higher than in short run.

(iii) Price level is higher than in short run.

(iv) Consumption remains unchanged at original level.

(v) Investment remains unchanged at original level.