Show the impact of tax reduction and simplification using the dynamic aggregate demand and aggregate supply model. Clearly show and identify the impact of the tax change. Assume that aggregate demand and short-run aggregate supply shift as they typically

do in the dynamic model. Show what happens to the price level and real GDP because of the tax change.

What will be an ideal response?

The economy's initial equilibrium is at point A. The movement from point A to point B illustrates the new long-run equilibrium that would exist in the economy with no tax change. This is an illustration of the economy that we'd typically expect in the dynamic model if the economy and aggregate demand were growing. The long-run aggregate supply will shift to the right from LRAS1 to LRAS2. Aggregate demand shifts to the right from AD1 to AD2. SRAS also shifts to the right from SRAS1 to SRAS2. The new long-run equilibrium in the economy is point B with a higher price level at P2 and a greater level of GDP at Y2. (The graph shows the AD shift relatively larger than the LRAS shift so the price level rises. This is arbitrary. The student could show the AD shift to be smaller relative to LRAS. The focus in this analysis is the movement from B to C.)

With the tax change, LRAS will shift by an even greater amount from LRAS2 to LRAS3. This shift in LRAS assumes that the tax reduction is effective and the economy experiences increases in labor supply, saving, investment, and the formation of new firms. Because of the tax change, the new equilibrium will be at point C rather than point B. The tax change lowers the price level from P2 to P3. This is a lower price level than what would have existed without the tax change. The tax change also increases output from Y2 to Y3.