Chapter 14, Problem 1RQ

To determine

Short run effect of increase in tax and long run effect of adjusting real interest rate.

Explanation of Solution

When the tax rate increases, the disposable income of the people will decrease, which in turn reduce the aggregate demand and cause shift in the AD curve to the left. As a result, GDP also will fall, which will create a recessionary gap in the economy; in turn, the inflation rate will decrease. The firms sell lesser quantity of output than they are willing to sell, which causes a rightward shift in the short run aggregate supply (SRAS) curve. This will lead to reducing price of the commodity. The firm decreases SRAS, until the short run supply curve equates the aggregate demand (AD) curve at the potential GDP level and actual inflation will fall.

Suppose, the Fed decided to adjust the real rate of interest in which investment and savings are equal. In the economy, there is higher level of taxation, which implies that the government has higher saving at the given level of spending. In order to stabilize the investment, the Fed will reduce the current rate of interest. As real rate of interest decreases, cost of borrowing decreases, which is an incentive for investment. As a result, new employment opportunities will increase and production increases. Hence, the aggregate demand also increases, which shifts the AD curve to the right. This offset the leftward shift of the AD curve occurred due to the increased tax rate. Accordingly, the total GDP will reach at the potential level, but the inflation rate will be much higher than the initial level.

Economics Concept Introduction

Aggregate demand (AD): Aggregate demand refers to the total value of goods and services that are demanded at a particular price in a given period of time.