301D, Practice problem set3-1

Based on your understanding of the aggregate supply

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13. Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect a tax cut will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Answer: A tax cut will cause an increase in consumption and a rightward shift in both the IS and AD curves. As demand increases, firms will increase employment to increase production. This will cause a reduction in u and an increase in W. As W increases, firms' costs rise and they raise prices. Once expectations adjust to the higher price level, the adjustment will be similar to that described in the textbook. The economy will return to the natural level of output at a higher price. The interest rate will be higher causing all of the increased consumption to be offset by the reduction in investment 14.  Analysis of the macroeconomic effects of changes in the money supply indicates that money is "neutral" in the medium run. Suppose there is an increase in government spending. Will this fiscal policy action also be neutral in the medium run? Explain. Answer: Changes in G are not neutral in the medium. Despite the fact that Y returns to its original level, two other real variables are affected by G in the medium run: the interest rate and investment. Specifically, the interest rate will be permanently higher causing I to fall. So, changes in government spending, while causing some real variables to return to their original levels, does cause changes in some other real variables.
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