Question

Suppose you put a policy in place that increases the tax on gas. How would you illustrate this policy decision using the Aggregate Demand and Aggregate Supply Model? How will the Price Level, Real GDP, and Employment be impacted in the short-run if this second most important policy decision was put into practice? How might the Price Level, Real GDP, and Employment be impacted in the long-run if this second most important policy decision was put into practice? Be detailed, specific, and clear.

Answer 1

If tax was increased on gas, people will have less money with them to spend on other goods which will reduce consumption of other goods and eventually reduce aggregate demand. It will reduce the price level from P to P1 and output level from Y to Y1. Fall in output level will reduce employment level.

In long run, producers will produce less of the goods which will shift supply curve to its left as there is fall in aggregate demand in short run to avoid inventories. It will raise price to its initial level while reduce output level further to Y2. Employment level will further fall in long run.