# Ch7 problem set answer key - Chapter 7 problem set Question...

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Chapter 7 problem set Question 2. Start at medium-run equilibrium, that is natural level of output and unemployment. Then suppose there is a tax cut. What happens in the IS-LM model and what happens in the AS-AD model? i P AS’ LM’ AS LM P 1 i 1 P 0 IS’ AD’ IS AD Y Y Y n Y 2 Y 1 Y n Y 2 Y 1 Let Y n designate the natural level of output. Let P 0 represent the initial price level. Step 1 : The decrease in taxes causes an increase in aggregate expenditure, which causes the IS curve to shift to the right. This yields an increase in Y and in i . (See the IS-LM graph above on the left.) Step 2 : The increase in Y in the IS-LM model is reflected in a rightward shift of the AD curve. (See the AS-AD graph above on the right.) Initially Y increases while prices remain at P 0 , as shown by the horizontal arrow in the AS-AD graph. Step 3 : The AS-AD disequilibrium puts upward pressure on prices. The increase in P means a decrease in M/P. A fall in M/P causes the LM curve to shift in/up. This drives up i even more, causing a partial reversal of the increase in Y. The shift up in the LM curve

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