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The AD-AS model can be used to analyze the effects of fiscal policy, including changes in...

The AD-AS model can be used to analyze the effects of fiscal policy, including changes in government spending or taxes. Suppose Congress votes to decrease corporate income tax rates. Use the AD/AS model to analyze the likely impact of the tax cuts on the macroeconomy. Show graphically and explain your reasoning. What exactly causes AD and/or AS to shift? What happens to GDP and the aggregate price level? Why?

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Decrease in taxes on corporate income will likely increase investment because now more funds will be available for investment. At the same time, if personal incomes taxes are reduced, disposable income increases which raises consumption. Since aggregate demand is composed of these two spending item, when there is an increase in consumption or investment, aggregate demand increases.

This shifts AD to the right. In the short run this is likely to raise GDP and the price level. GDP rises because demand for goods and services increases. Prices are increased because they are assumed to be flexible in the short run and firms cannot increase production to match the aggregate demand in the short run. This puts upward pressure on the general price level so it rises.

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