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3. Suppose the economy begins with output equal to its natural level.
Then, there is a reduction in income taxes.
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a. Effect of a reduction in income taxes on the position of the AD, AS,
IS, and LM in medium run.
LM
i2
i1
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i0
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P3
Income tax reduction means higher income perceived by society. In the short
run, increase in income rises consumption, and therefore increase the output
(Y). As the output increases, in the medium run the price also increase
exceeding the expected wages. Therefore, the wages are also increased. The
increasing of wages means higher production cost experienced by
companies, leads to decrease in output and price increases. These condition
is shifting the AS curve to the left to AS, which moving the point of output
back to natural.
b. in the medium run,
output level goes back to natural level,
interest rate increases
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