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1. A Demand Shock Suppose that the government reduces taxes. Predict what should happen to income,...

1. A Demand Shock

Suppose that the government reduces taxes. Predict what should happen to income, interest rates, and the price level in the short run and in the long run. For the purposes of this question ignore any supply-side effects of the tax cuts. Assume that the world is not Ricardian.

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Answer #1

If the government reduces tax, income (the real income) of people will rise in short run, but in the long run, they will accordingly increase their demand making it back to normal of even lesser.

Interest rates will rise in order to encourage investment in the short run but will cone back to normal in long run.

Price level will increase in short run as as aggregate demand would boost drastically due to tax cut, in short run. But will be normalized later as, demand would adjust itself.

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