Suppose that the federal government decides to reduce the budget deficit and cuts government purchases by $200 billion and raise personal income taxes by $200 billion. Suppose the MPC = .5. a. How much and in which direction would the AD curve shift because of the government spending cut? b. How much and in which direction would the AD curve shift because of the tax increase? Show your work. c. Using the above numbers, draw the AS-AD diagram and illustrate the short-run impact of the combined policy action assuming the economy begins at potential output. Label the original equilibrium with point "A" and the new short-run equilibrium with point "B". d. Describe the impact of the policy action on employment/unemployment, spending, and prices/inflation. Be sure to include the impact of the spending multiplier. e. In moving from points "A" to point "B" on the AS-AD diagram, why do firms change their production? f. Characterize the labor market at point "B". g. Describe the process of why eventually wages and prices fully adjust. h. Illustrate the impact of the wage and price adjustment using the AS-AD diagram. Label the new equilibrium as point "C".
Suppose that the federal government decides to reduce the budget deficit and cuts government purchases by $200 billion and raise personal income taxes by $200 billion. Suppose the MPC = .5.
a. How much and in which direction would the AD curve shift because of the government spending cut?
b. How much and in which direction would the AD curve shift because of the tax increase? Show your work.
c. Using the above numbers, draw the AS-AD diagram and illustrate the short-run impact of the combined policy action assuming the economy begins at potential output. Label the original equilibrium with point "A" and the new short-run equilibrium with point "B".
d. Describe the impact of the policy action on employment/
e. In moving from points "A" to point "B" on the AS-AD diagram, why do firms change their production?
f. Characterize the labor market at point "B".
g. Describe the process of why eventually wages and prices fully adjust.
h. Illustrate the impact of the wage and price adjustment using the AS-AD diagram. Label the new equilibrium as point "C".
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