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Consider the Aggregate Demand-Aggregate Supply framework; assume expected inflation is always zero. Starting at Yn, suppose...

Consider the Aggregate Demand-Aggregate Supply framework; assume expected inflation is always zero. Starting at Yn, suppose a tax cut is implement which (i) increases disposable income, and (ii) increases the incentive to work so that labor supply increases. Show the immediate effect in an AD-AS graph.

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Answer #1

Decrease in taxes generally lead to higher disposable incomes and hence the employee productivity also rises and labor supply rises due to better wages. This further leads to rise in aggregate demand as consumption increased. Due to this the prices also rise causing inflation to rise from zero levels and thus the GDP grows as well due to higher aggregate demand .

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