Question

Suppose a government decides to increase taxes. 30. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of on GDP. Be sure to label the axes, the curves, the initial equilibrium values, the direction curves shift, and the terminal equilibrium values.

Answer 1

30. Suppose the economy initially operates at long run equilibrium at point A. Initial long run equilibrium price level is P1 and real GDP or potential GDP is Yp.

Then the government decides to increase taxes. This will decrease disposable income, and thereby decreasing Consumption spending. As a result, aggregate demand decreases. This will shift the AD curve leftward from AD1 to AD2. Short run equilibrium occurs at point B. Short run equilibrium price level decreases to P2 and equilibrium real GDP decreases to Y2. As inflation decreases, real wages of workers increases. Therefore, employers pay less wages to workers. As a result, short run aggregate supply increases, shifting the SRAS curve rightward from SRAS1 to SRAS2. New long run equilibrium occurs at point C. Therefore, price level further decreases to P3 and real GDP goes back to the long run potential GDP, Yp.