Question

59. Review the problem shown in the Work It Out titled "Interpreting the AD/AS Model." Like the

information provided in that feature, Table 24.2 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.

Price Level       AD       AS

110                  700      600

120                  690      640

130                  680      680

140                  670      720

150                  660      740

160                  650      760

170                  640      770

Table 24.2 Price Level: AD/AS

a. Plot the AD/AS diagram from the data shown. Identify the equilibrium.

b. Imagine that, as a result of a government tax cut, aggregate demand becomes higher by 50 at

every price level. Identify the new equilibrium.

c. How will the new equilibrium alter output? How will it alter the price level? What do you

think will happen to employment?

Answer 1

Price Level (S) 110 120 130 140 150 160 170 Aggregate Supply (AS) Aggregate Dend 1 (AD1) Aggregate Demand 2 (AD2) 600 640 680 720 740 760 770 700 690 680 670 660 650 640 750 740 730 720 710 700 690 Initially the economy is in equilibrium at the intersection of Aggregate Supply (AS) curve and Aggregate Demand 1 (AD1) curve with equilibrium price level of $130 and equilibrium quantity of 680. Now, it is given that as a result of the decline in the taxes by the government the aggregate demand has increased by 50 at every price level. This is shown as the shift of the aggregate demand curve rightward from AD1 to AD2 in the following diagram 180 160 140 120 100 80 E 60 40 20 0 600 620 640 660 680 720 740 760 780 800 Quantity Aggregate Supply (AS) Aggregate Demand 1 (AD1) Aggregate Demand 2 (AD2) The equilibrium price has in creased to $140 and equilibrium quantity has also increased to 720. Reduction in the taxes raises the disposable income of the individuals which will raise the level of aggregate demand in the economy through the multiplier effect. Increased demand will raise the income level. For a given level of money supply an increase in the income level raises the transaction demand for the money. This will cause the bond prices to decline and interest rate to rise as people will start to withdraw from their speculative balances to finance their increased transaction needs. Increase in the interest rate will cause the investment demand to decline as firms will find it expe nsⅣe to borrow to purchase machine, equipment and plants. So, reduction in the taxes will raise the share of consumption in the total output, while the share of investment will decline Increase in the demand will also raise the level of employment in the econom