Final answer:
If corporate taxes are temporarily lowered, ceteris paribus, the policy change will cause the economy to move into an inflationary gap and will cause the price level to increase. The correct answer is A) Inflationary, increase.
Step-by-step explanation:
Lower corporate taxes increase the after-tax income of businesses, leading to higher investment spending or increased distributions to shareholders, which in turn can boost consumption.
Because corporate tax cuts can stimulate additional demand in the economy, they often cause aggregate demand (AD) to shift to the right. When the AD curve shifts to the right while the economy is at or near potential output, this results in an upwards pressure on the general price level. This is because, in the short run, the aggregate supply (AS) may be relatively inelastic – depicted as a vertical line at potential GDP – and unable to respond with more output, thus leading to higher prices instead.
In Keynesian economics, when aggregate demand increases, it can push the economy beyond its potential output, creating an inflationary gap. To mitigate this, contractionary fiscal policies such as tax increases or government spending cuts are usually recommended.
The correct answer is A) Inflationary, increase.