Please see graph above A) Using the letters in the diagram, identify the price a

Question

Please see graph above

A) Using the letters in the diagram, identify the price and output level with the economy operating at full capacity by completing the following (cut and paste the italicized text into the answer space and fill in the blanks so we can clearly tell which label belongs to which description): The aggregate demand curve that best corresponds to the description above is given by the label ____. The equilibrium price is given by the label ____ and the equilibrium output level is given by the label ___.

B. Using your answer to (A) as a starting point, suppose the government implements a “small” tax cut, holding constant government purchases and all other factors affecting the AD curve. Describe the short run effects of the tax cut in the diagram above. Include appropriate references to the labels given in the graph. In 1-3 sentences describe which curve(s), if any, is/are affected and give an example of the resulting equilibrium following the tax cut. Keep it brief because in part (C) you will add to your description.

C. In part (A) we focused on the initial state of the economy. Then in part (B) we focused on a tax cut. Give a 2 - 5 sentence explanation about why the initial state of the economy matters when determining the impact of the tax cut in (B) above. To do this, contrast the result in (B) above to the result of the policy if the economy was operating well below capacity. Feel free to use other labels in the graph as references.

Explanation / Answer

A.1. Full capacity AD = F

2. Price = i.

3. Output = n.

The full capacity is considered when the AS is almost vertical and there is no further or very little scope of any increase in output in the economy. Also, all the resources engaged in the production process are working at their full capacity.

B. After a tax cut, the new AD = G.

Price = h.

Output = a.

With a tax cut, the consumption spending of the consumers increase. Consumption being a component of AD, shifts the AD curve to the right. As the economy is operating at the full capacity, the increase in price level is more than the increase in output.

C. The state of the economy matters because the resulting impact of a tax cut or any other policy change differs with the state of the economy. In part B above, initially the economy was operating near full capacity and there was no tendency to expand further. An increase in spending would only drive the demand for goods and services upwards which would further increase the price level. Contrasting this situation, had the initial state of the economy been with AD as D with price and output as k and l respectively, then a tax cut would increase the AD to E, with price and output as j and m resp. Now the tax cut has increased the output more than the increase in price. This is because at this point the economy is not under full capacity, there is tendency to grow and expand because of which the price increase is less than output growth.

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