Question

Suppose the economy is initially in long-run equilibrium and the government reduces the marginal tax rate....

Suppose the economy is initially in long-run equilibrium and the government reduces the marginal tax rate.

a. What will happen to output and inflation if the effects of the tax cuts are stronger on aggregate demand than on potential GDP?

show the changes in AD and Y*.

Both the AD and Y* (potential output) curves will shift to the left, so output and inflation will decrease.
The AD curve will shift to the left more than the Y* (potential output) curve, so output will increase and inflation will decrease.
The AD curve will shift to the right less than the Y* (potential output) curve, so output will decrease and inflation will increase.
The AD curve will shift to the right more than the Y* (potential output) curve, so output and inflation will increase.




b. How will output and inflation be affected if the effects of the tax cuts are stronger on potential GDP than on aggregate demand?

show the changes in AD and Y*.

The Y* (potential output) curve will shift to the right more than the AD curve, so output will increase and inflation will be lower.
The Y* (potential output) curve will shift to the right and the AD curve will shift to the left, so output will be the same and inflation will be lower.
The Y* (potential output) curve will shift to the right less than the AD curve, so output will increase and inflation will be higher.
Both the Y* (potential output) and AD curves will shift to the left, so output will fall and inflation will be higher.


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Answer #1

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1 D is right. Lower tax means greater disposable income and thus greater demand Lower taxes also increase winngness to work more shifting LRAS and thus potential output rightwards. BUT AD shifts more than LRAS as effect on demand is more than output. See fig 1. Clearly output rises and so does inflation but shift in AD is more than in Y2-Y1 (shift of potential output)

2 A is right. Reasoning is same as in A. Clearly shift in potential output (Y2-Y1) is greater than in AD. Also output rises from Y1 to Y2 but prices fall from p1 to p2. See fig 2

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