Homework Assignment

1. Use an aggregate/supply diagram to analyse the likely effects of an increase in income tax.
I am going to consider the short run and the long run separately and I am going to distinguish between the Keynsian and the Classical models. a) Short run. In the short run those two models do not differ. The diagram for the aggregate demand and the aggregate demand, after an increase in income tax is shown below:

After an increase in the income tax the consumption will substantially decrease, as people will have less money and they will spend less money. Therefore we will observe a shift in the Aggregate demand to the left, as it is shown on the graph. The price will decrease from P1 to P2 and the quantity from Q1 to Q2. The new equilibrium output will be set.

In the long run, at the Keynsian model, there are two possible situation, which depend on the current level of unemployment. The diagram below shows how the shift in the demand will influence the level of price and the level of output at the big level of unused resources:

On the graph it is clearly visible, that, when there is a high unemployment, a shift in demand to the left will lead to a big decrease in the quantity of the real output and a low decrease in price.

The graph below presents how the situation would look level at a full level of employment:

What we can see is, that the quantity would decrease in not a substantial way, whereas the change of price would be very significant. In the long run in the Classical model the effects would be purely deflactionary. It is clearly visible on the graph below:

We can see, that in the Neo-Classical point of view there is no change in the Quantity of the real output. The only change is in the price level, what indicates that the changes are only, purely deflationary. The price level decreases from P1 to P2.

Question 2
In my opinion an increase of the interest rates will have the same effect like in the first question. Interest rates are usually substantially involved into any investments. If the interest rates increase, than the investors have less money. The tension also arises, and people become more stressed and they make not reasonable decisions. I have decided not to explain everything again, as in my opinion the situation is homogenous to the first question. Question 3 a) A general increase in wage costs would increase the costs of production, as the investors would have to pay more for the labour force. Therefore, the supply curve will shift to the left, because it will cost more to produce. Again, I will consider the short run and long run separately, and distinguish between the neo-classical and Keynesian point of view. The graph below represents the changes in the short run in the neoclassical and Keynesian models:

On the graph it is visible, that the real output changes from the Q1 to Q2, while the price level rises from P1 to P2. There is a new equilibrium output set. Now I am going to consider how will this occurrence influence the price and the quantity in the long run. The effect in the neo-classical model would be, as it is shown in the graph:

The price rises from P1 to P2, and the Quantity decreases from Q1 to Q2. We can see, that the LRAS graphs are vertical and the only thing that influences the changes is the demand. However, the Keynesian theory suggest, that there are two different possibilities, which are dependent on the level of the demand.

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