Question

This question compares the effects of a tax cut on aggregate demand and aggregate supply. A tax cut of 150 is targeted to business enterprises so that, as their after-tax profits rise, they raise their spending on investment goods by the full 150. When subsequent rounds of increases in income occur, however, there is a normal marginal propensity to consume, and a multiplier of two. Investment has the following effect on aggregate supply: for every $3 of investment goods produced, annual output rises by $1.a) What increase in aggregate demand will result from this tax cut?b) What increase in aggregate supply will occur in the first year?c) Comparing your answers in a) and b), which impact is bigger?d) Assuming the tax reduction is permanent, how many years will it take before the effects on aggregate demand and aggregate supply are equal?e) Suppose the tax cut is not quite as well targeted toward the supply side as the government hoped. Of the cut of 150, initially 60 is spent on investment, 60 is spent on consumption, and 30 is saved. Answer questions a) through d) above under these circumstances.

Answer 1

Check the following explanation.

Step-by-step explanation:

Ans a - Aggregate demand will increase by $150.

Ans b - Aggregate supply will increase by $50 in the first year.

Ans c - The aggregate demand impact is bigger.

Ans d - If the tax reduction is permanent then the aggregate demand and aggregate supply will be equal in 3 years.

Ans e - The aggregate demand increases by 120. The aggregate supply increases by 20. The aggregate demand impact is bigger. If the tax reduction is permanent then the aggregate demand and aggregate supply will be equal in 6 years.