Question

The graphs illustrate an initial equilibrium for the economy. Suppose that the government cuts taxes.

Use the graphs to show the new positions of aggregate demand (AD), short‑run aggregate supply (SRAS), and long‑run aggregate supply (LRAS) in both the short run and the long run, as well as the short‑run and long‑run equilibriums resulting from this change. Then, indicate what happens to the price level and real GDP (or aggregate output) in the short run and in the long run.

In the short-run, the price level __________ and GDP __________.
In the long-run, the price level __________ and GDP __________.

WORD BANK
increases
decreases
stays the same

Answer 1

Answer:

In the short-run, the price level increases and GDP increases.

In the long-run, the price level increases and GDP stays the same.

Explanation:

When the government cuts taxes, consumers have more disposable income and increase spending. This shifts the AD curve to the right.

Short run: Neither the SRAS nor LRAS curves shift in the short run in response to the increase in aggregate demand. The new equilibrium point is the intersection of the shifted AD curve with the SRAS curve.

Long run: The aggregate demand increase looks the same on the long‑run graph as it does on the short‑run graph. As the higher price level causes expectations to change, the SRAS curve then shifts such that it intersects the AD and LRAS curves at the same point. As was the case in the short run, the LRAS curve itself does not move, as it only shifts when the economy's potential output changes due to factors like technological progress.

The long‑run equilibrium point is then the intersection of AD, SRAS, and LRAS.