Illustrate and explain the effects of tax reduction and simplification using the dynamic aggregate demand and supply model. To simplify the analysis, assume that aggregate demand is not affected by the tax cut

Question

What will be an ideal response?

Answer 1

The economy's initial equilibrium is at point A. The movement from point A to point B illustrates the new long-run and short-run equilibrium that would exist in the economy with no tax change. The long-run aggregate supply will shift to the right from LRAS1 to LRAS2 due to normal growth. The short-run aggregate supply curve will shift with the LRAS curve. The new long-run and short-run equilibrium in the economy is point B with a lower price level at P2 and a greater level of GDP at Y2.
With the tax change, LRAS will shift by an even greater amount from LRAS2 to LRAS3. The short-run aggregate supply curve shifts from SRAS2 to SRAS3. These shifts in LRAS and SRAS assume that the tax reduction is effective and the economy experiences increases in labor supply, saving, investment, and the formation of new firms. Because of the tax change, the new equilibrium will be at point C rather than point B. The tax change lowers the price level from P2 to P3. This is a lower price level than what would have existed without the tax change. The tax change also increases output from Y2 to Y3. This is a greater level of output than what would have existed without the tax change.