Question

Using the AD-AS model, an economy is at its long term equilibrium, growing at 1%. Government...

Using the AD-AS model, an economy is at its long term equilibrium, growing at 1%.
Government decides to reduce taxes and increase government spending.
What changes will be seen in the AD-AS model, how will the graph look, what effect does it have in economy?

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Answer #1

Because the government has influence over several of the components of aggregate demand, it has the power to shift AD through its policy choices. Government spending—one component of AD. Higher government spending causes AD to shift to the right. Tax policy can affect consumption and investment spending as well. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Since both consumption and investment are components of aggregate demand, changing either will shift the AD curve as a whole.

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