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Week 10, Day 2 - Assignment 5 Solutions

Week 10, Day 2 - Assignment 5 Solutions - ASSIGNMENT#5...

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ASSIGNMENT #5 SOLUTIONS 1. a) b) In 1987, the economy was in long-run equilibrium (point A in the graph). The cut in income taxes increased disposable income. Households increased their consumer spending and aggregate demand (AD) increased. The AD curve shifted to the right from AD1 to AD2. As a result, the economy moved to a new equilibrium (point B in the graph). The price level increased and real GDP increased. c) The income tax cuts caused an inflationary gap since the new equilibrium level of real GDP was higher than the potential level of output (Y P ). d) When an inflationary gap exists, the long-run automatic adjustment process occurs. Since real GDP (at point B) is above the potential level of output (Y P ), unemployment is relatively low (ie unemployment is below the natural rate). Nominal wages increase, production costs increase, and profit per unit of output for producers decreases. The short run aggregate supply (SRAS) curve shifts to the left (from SRAS1 to SRAS2).
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