Question

49. Suppose now that the government decides to use fiscal policy to ameliorate the effect of the negative shock on investment. Use the model of aggregate demand and aggregate supply provided below to illustrate graphically what the government can do to respond to the sudden decrease in investment, and what the impact of government action will be, in the long-run, on prices and output. You must explain each step of the process. Price level 1 Quantity of Output

Answer 1

Solution-

Aggregate demand is the total planned expenditure by the household and firms during a given period of time. It is also the total demand for goods and services that occurs at a given price level in a certain time period.

Aggregate demand = C+I+G+NX, where C is Consumption level, I is Investment, G is Government spendings and and NX= net exports.

Consumption function C= A+bYd, here A is that level of Consumption which is independent of income level, b is marginal propensity to consume and Yd is disposable income, an income which is left after paying the taxes.

Long run AS curve is vertical because the economy is operating at full employment level, it has utilized it's resources fully. Output can't be increased beyond this level.

Yd= Y-T

• When taxes are reduced, then disposable income of a consumer rises. So due to rise in disposable income, it's spending on consumption also rises. It will result in increase of AD. AD curve shifts rightwards. It will result in rise in equilibrium price level but equilibrium output will remain stagnant as in the long run the economy is at its full potential level/employment level.
• When government spending rises, Aggregate demand in the economy also rises. AD shifts rightwards. As in the long run, the economy is at its full employment level so output can't be increased but price level in the economy rises.

These can be depicted by the below given diagram-

LRAS Price SRAS level pi......... DE ..AD SRAD/AD Yo quantity of output Initial Equilibricem Eo Final Equilibrium El Po increases to P, 'Yo outpect level remains the same in the long run. O

So going by the options, only option which is correct is a.( decrease in tax will rise price level and output level remains same in the long run.)