Question

2.    We now want to study the same fiscal policy if the economy starts at full employment.

(i)            Draw the aggregate demand curve and the short and long run supply curves for a country in a new diagram. Assume that the country starts at full employment.

(ii)           The government decides to reduce taxes to households. Illustrate in your diagram the effect on the economy of lower taxes by shifting the curve(s). Mark the new short-run equilibrium after lower taxes P2, Y2. What happened to output and the price level? What is the situation in the labor market in the new short-run equilibrium? (Is unemployment high/low?)

(iii)          Show what will happen to this economy in the long run and explain briefly. In the end, what was the change in output and prices from before the tax reduction to the new long run?

Answer 1

ii) when government reduced taxes, then the people left with more disposal income or people disposable income increase which increase aggregate demand in the economy and thus AD curves shift upward. The output and price will increases. In the labor market , the level of unemployment will be low because as the AD is high , then business will hire more labor to produce goods and hence employment increases.

iii) in long run, the short run aggregate supply increase and SRAS curve shifts to upward ,the economy producing at the full employment output but at the higher price level.