Question

The assignment is about drawing the graph of AD, SRAS and LRAS and writing down what would happen under the condition "decrease in personal income taxes"

Need to write down everything that happens by following the seven steps:

1) What would happen under the condition? (Whether AD, SRAS, or LRAS would change? And in which direction the curve would shift?)

2) Where is the new short-run equilibrium? (You need to mark the point in the graph.)

3) What changed in the new short-run equilibrium? (Price level/real GDP goes up/down when comparing with the initial equilibrium)

4) Is the short-run equilibrium under-producing or over-producing? What would happen in the labor market?

5) What would happen next? (Whether AD, SRAS, or LRAS would change? And in which direction the curve would shift?)

6) Where is the new long-run equilibrium? (You need to mark the point in the graph.)

7) What changed in the new long-run equilibrium? (Price level/real GDP goes up/down when comparing with the initial equilibrium)

Answer 1

A decrease in personal income tax will increase consumers' disposable income, increasing personal consumption expenditure. Higher consumption will increase aggregate demand. AD curve will shift to right, increasing both price level and real GDP, causing an expansionary gap in short run. A rise in real GDP will reduce unemployment rate in labor market.

In the long run, higher price level will lead to higher wages and input prices, causing firms' production costs to rise. Firms will reduce output, lowering aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring real GDP to potential GDP level, removing the short-run expansionary gap. Unemployment rate will fall back to natural (full-employment) rate.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (which is equal to potential GDP) Y0. When aggregate demand increase in short run, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real output Y1, with short run inflationary gap of (Y0 - Y1). In the long 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, removing the short-run expansionary gap.

LRASO SRAS SRASO ADO H YO Y