Question

When Bob Dole ran for President in 1996, he proposed large permanent tax cuts. If an economy starts at potential output, explain the effects on the economy of large permanent tax cuts in both the short and long run. Be sure to explain how output, prices, interest rates, investment and consumption are affected in the short run and the long run. Your answer should be one page typed with any and all appropriate mathematics, graphs and explanations.

Answer 1

In short run, with tax cuts, disposable income will rise (Income left after paying taxes) which will leave more money to spend on goods and services and raise the aggregate demand in the economy and shifts aggregate demand curve to its right from AD to AD1. It will raise the price level from P to P1 and output level from Y to Y1 in short run. A rise in aggregate demand will shift the IS curve to its right from IS to IS1, raising its rate of interest from "i" to "i1" and level of output from Y to Y1. In short run, people will cut their investment level as rate of interest have increased.

In long run, producers will try to sell more of the goods because prices have increased in the economy. It will shift the supply curve to its right because producers can only raise their production in long run. A rightward shift in supply curve will reduce the price to its initial level while raising the output level further.

In response to higher rate of interest, Fed will raise their money supply in long run to reduce the rate of interest which will shift the LM curve to its right reducing the rate of interest to its initial level and raising output level.