Question

Use the ADI-IA diagram, show how a decrease in taxes affects the economy in the short run and long run. Assume that the economy initially has an inflation rate of π0 and full-employment output at Yf.

Answer 1

According to the aggregrate demand inflation adjustment model, if there is a decrease in tax in the economy , people will have more money in the hand thus they will spend more expenditure will increase and demand will increase thus AD curve will shift right ward. In the short run thus real GDP will be above of the potential level or full emplyment level Yf. But inflation rate will be same as π0

but in the long run,nas increase in demand will lead to have an increase in price thus inflation adjustment line will go up until the real GDp goes back to potential level Yf at higher inflation rate π1.