Question

The government raises personal income taxes. Use the aggregate supply and demand model to explain the impact of this move on aggregate supply, demand, equilibrium price level, and real GDP. Make sure you start in long run equilibrium before the tax change.

Answer 1

Increase in personal income tax will decrease disposable income, which will decrease consumption demand. This will decrease aggregate demand, shifting AD curve leftward and decreasing both price level and real GDP. Unemployment increases and a recessionary gap arises in short run. Aggregate supply remains unchanged.

In following graph, initial full-employment equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP (same as potential GDP) Y0. When person tax increases, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).