Consider an economy operating below its full-employment output level. The govern
ID: 1168992 • Letter: C
Question
Consider an economy operating below its full-employment output level. The government wants to enact a reduction in income taxes in an effort to restore the economy to full-employment output. On the graph that follows, shift one of the curves to illustrate the impact of the income tax cut on aggregate supply (SRAS) and aggregate demand (AD) that is emphasized by demand-side economists. Tool tip: Click and drag the curve. The curve will snap into position, so if you try to move the curve and it snaps back to its original position, just try again and drag it a little farther. On the graph that follows, shift one of the curves to illustrate the dominant impact of the income tax cut according to supply-side economists. Use the dropdown menus to fill in the table and complete the causation chains for the demand-side effects and supply-side effects of the income tax cut.Explanation / Answer
Answer 1
From perspective of Demand-side economists -
According to demand-side economists, any cut in income tax increases the disposable income of households.
As income and consumption are directly related, this increase in disposable income induces the households to consume more.
This increases the consumption spending in the economy which in result will increase the aggregate demand.
So, aggregate demand curve will shift rightward or outward.
With aggregate supply curve remaining unchanged, this rightward shift of AD curve will lead to increase in the level of real GDP and will also bring an increase in price level.
So, expansionary fiscal policy in terms of,
1. Income tax cuts
2. leads to increase in consumption spending
3. resulting in rightward shift of aggregate demand curve
4. leading to increase in real GDP and the rise in price level
Answer 2
From the perspective of Supply-side economists -
According to Supply-side economists, any cut in income tax increases the preference of workers for work over leisure as their in-hand pay at each wage level increases.
This induces them to supply more labor. As labor supply increases, production in the economy also increases.
So, aggregate supply in the economy increases and due to this aggregate supply curve will shift rightward or outward.
With aggregate demand curve remaining same, this rightward shift of SRAS curve leads to increase in level of real GDP and brings a fall in price level.
So, expansionary fiscal policy in terms of
1. Income tax cut
2. leads to increase in supply of labor and output produced
3. resulting in rightward shift of aggregate supply curve
4. leading to increase in real GDP and the fall in price level