Fiscal Policy Analysis

-On the graph above, suppose the economy is at point 1. Which sequence of points best illustrates the short-run and then long-run impacts of a permanent tax reduction? [Assume that potential output remains constant at Y .]

Question

Fiscal Policy Analysis
 
-On the graph above, suppose the economy is at point 1. Which sequence of points best illustrates the short-run and then long-run impacts of a permanent tax reduction? [Assume that potential output remains constant at Y  .]

Quizplus · Accepted Answer

- A permanent tax reduction would shift the aggregate demand (AD) curve to the right, from AD1 to AD2. This would cause an increase in output from Y1 to Y2 in the short-run.
- However, in the long-run, the increase in demand would lead to an increase in prices, causing a leftward shift of the short-run aggregate supply (AS) curve from AS1 to AS3. This would cause output to return to its initial level at Y1, but at a higher price level.
- As the economy moves from point 2 to point 7, there is an increase in output but also an increase in prices. This represents the short-run impact of the tax reduction.
- As the economy moves from point 7 to point 6, output returns to its initial level at Y1, but prices remain higher due to the leftward shift of the short-run AS curve. This represents the long-run impact of the tax reduction.
- Therefore, the sequence of points that best illustrates the short-run and long-run impacts of a permanent tax reduction is 2, 7, 6, making choice C the correct answer.

Fiscal Policy Analysis -On the Graph Above, Suppose the Economy Is at Point