Question

Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, show how each of the following government policies will impact the economy. In each case, what are the effects on the aggregate price level and aggregate output?

1. There is a decrease in taxes on households
2. There is a decrease in government spending.

Answer 1

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1. Decrease in taxes on households:

The decrease in taxes on households will increase the disposable income of households, which will increase their consumption spending. This increase in consumption spending will shift the aggregate demand (AD) curve to the right, resulting in an increase in both the aggregate price level (P) and aggregate output (Y) in the short run. However, in the long run, the increase in aggregate demand will lead to an increase in the price level, which will cause a decrease in the purchasing power of money and a decrease in consumption spending. As a result, the short-run aggregate supply (SRAS) curve will shift to the left, resulting in an increase in the price level and a decrease in aggregate output in the long run.

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2. Decrease in government spending:

The decrease in government spending will decrease the aggregate demand (AD) curve, as the government is spending less money on goods and services. The decrease in aggregate demand will shift the AD curve to the left, resulting in a decrease in both the aggregate price level (P) and aggregate output (Y) in the short run. However, in the long run, the decrease in aggregate demand will lead to a decrease in the price level, which will cause an increase in the purchasing power of money and an increase in consumption spending. As a result, the short-run aggregate supply (SRAS) curve will shift to the right, resulting in a decrease in the price level and an increase in aggregate output in the long run.