Question

Suppose Congress votes to decrease corporate income tax rates. Use the AD/AS model to analyze the likely impact of the tax cuts on the macroeconomy. Show graphically and explain your reasoning. What exactly causes AD and/or AS to shift? What happens to GDP and the aggregate price level? Why?

Answer 1

When government decreases corporate income tax, business profitability increases. So firms increase business investment. Higher investment spending increases aggregate demand, shifting AD curve rightward and increasing both inflation and real GDP. Unemployment decreases.

In following graph, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP Y0. When tax decreases, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.