Question

Tax reduction would increase output and employment of the U.S. economy in the long-run. Is this...

Tax reduction would increase output and employment of the U.S. economy in the long-run. Is this true in AD-AS model? Why? Why not? Justify your answer using the AD-AS diagram.

please state yes or no.

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Answer #1

No, tax reduction will only increase the output and employment of the US economy in the short run and leave the output same at the potential level in the long run.

In the below graph the tax cut will increase the employment in the short turn by increasing the output. Initially, the equilibrium was at point A, the price P, and output Y1. After the tax reduction, the output will increase to Y2 in the short run and decrease the unemployment.

This will also increase the price and but at the new higher price the real wages will decrease. IN the long run, the economy will adjust to the new wages and come back to the long run equilibrium i.e. the output will be back to Y1.but at a higher price P3.

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