Assume the federal government raises taxes (a contractionary fiscal policy).If the tax increase affects AS and AD equally,then real GDP will ________ and the price level will ________.

Question

Quizplus · Accepted Answer

If the tax increase affects aggregate supply (AS) and aggregate demand (AD) equally, then the effect on real GDP and the price level will be opposite and cancel each other out. A tax increase will decrease AD because it reduces disposable income and consumption, but it will also increase AS because it reduces the marginal cost of production and encourages firms to supply more output. The net effect of these two forces, however, is uncertain and depends on other factors, such as the slope, position, and shift of the AS and AD curves. In general, the short-run impact of a tax increase on real GDP and the price level is ambiguous and depends on the context and assumptions. However, in the long-run, a tax increase is likely to decrease real GDP and increase the price level, due to the negative effects on investment, labor supply, and productivity.

Assume the Federal Government Raises Taxes (A Contractionary Fiscal Policy)