MACROECONOMICS GROUP PRESENTATION

CONTINUOUS ASSESSMENT- 2023

HINDU COLLEGE

PRESENTED BY- GROUP:-09

 YASH- 04 SUBMITTED TO-

 ARNAV- 77 MRS. ARCHANA AGGARWAL
 DISHA- 165
 Aanya- 200
 ANSHUL- 440
 VISHAL- 461
 NISHTHA- 476
 KRATI- 503
 HARSHIKA- 549
 CHIRAG- 757
 DRON- 814
QUES- Assume an economy that starts at the natural rate of output. Let government
decrease the Income Tax in the economy. If the Income Tax cut does not impact the
supply of labour, which curve will be impacted in AD-AS diagram? Show the effect of
policy on output and prices in the short run and in the medium run. If the tax rate
were to impact the supply of labour, how would AS be affected?
Assumptions-
1. Economy starts at natural employment level.
2. There is no inflation, that is - prices are constant over time.

Solution:-
The government imposes a policy to cut (reduce) Income Tax which leads to increase
in the consumption in an economy. Reduction in the Income Tax increases the
Disposable Income of the consumers [As Disposable Income=Y(Income)-T(Taxes)]
and Consumption(C); being a positive function of disposable income also increases.
Now, this increase in Consumption leads to the increase in Aggregate Demand (AD) in
the economy.
Here, Government has imposed an Expansionary Fiscal Policy as there has been a
increase in the Aggregate Demand.

Fiscal Policy- Fiscal policy is a critical tool used by the government to manage the
economy through changes in government spending, taxation, and borrowing. Its main
objectives are typically to influence economic growth, employment levels, price
stability, and the distribution of income and wealth within a country.
Key Components are:-
1. Government Spending: The government uses public expenditure on various
goods and services, such as infrastructure, healthcare, education, defence, and
social welfare programs. Increasing government spending can stimulate
economic activity and aggregate demand, promoting economic growth and
employment.

2. Taxation: Taxes are used by the government to finance its activities and achieve
specific economic objectives. Tax policies can be adjusted to influence
aggregate demand.
 3. Fiscal Deficit and Surplus: The fiscal deficit occurs when government spending
exceeds government revenue (taxes and other income). Conversely, a fiscal
surplus occurs when government revenue exceeds spending. Governments aim
to manage these to maintain fiscal sustainability and ensure that debt levels are
manageable.

Expansionary Fiscal Policy- Expansionary Fiscal Policy refers to a set of measures

taken by a government to increase Aggregate Demand within an economy. This type
of fiscal policy involves increasing government spending or decreasing taxes, or a
combination of both, to expand or boost the economic activities.

Effect of Expansionary Policy on Position of AD-AS and IS-LM Curve:-

Now, here the Income Tax cut has no impact on the labour supply. So, there will be no
effect on the AS Curve due to this tax cut.

Short Run:-
Assume that output is initially at the natural level of output, so that the economy is at
point A. Output equals Yn. Due to decrease in income taxes, there is an increase in the
disposable income of the consumer and hence consumption increases. As a result,
Aggregate Demand curve shifts to the right from AD to AD’. In the short run, the equilibrium
moves from A to A’ and output increases from Yn to Y’ and price level increases from P to P’.
Before the change in fiscal policy, the equilibrium is given by the intersection of the IS
curve and the LM curve, at point A- which corresponds to point A of the AD Curve.
Output is equal to the natural level of output Yn and interest rate is given by i.
As the government reduces the taxes, the IS curve shifts to the right to IS’. If the price
level did not change, the economy would move from point A to point B. But, because
price level increases; in response to the increase in output, the real money stock
decreases, leading to partly offsetting shift of the LM curve, left to LM’. So, initial
effect of increase in taxes is to move the economy from point A to point A’. Both
output and the interest rate are higher than before the fiscal expansion.

Medium Run:-
As long as the output is above the natural level of output, we know that the aggregate
supply curve keeps shifting upward. The economy moves down along the aggregate
demand curve AD’ until the aggregate supply curve is given by AS’’ and the economy
reaches point A’’. By then, the output is back at Yn.
Eventually, output returns to its natural level. At point A’’, not everything is the same
as before. Output is back to the natural level of output, but the price level and the
interest rate are higher than before the shift.
As long as the output remains above the natural level of output, the price level
continues to increase, leading to a further decrease in the real money stock. The LM
curve continues to shift leftward. The economy moves down from point A’ along the
IS’ and eventually reaches A’’. At A’’, the LM curve is given by LM’’.
At A’’, output is back at the natural level of output. But the interest rate is higher than
it was before the tax was reduced, up from i to i’’.
  In Medium Run:- Y=Yn and P=Pe
 In Short Run:- Y>Yn and P>Pe
 The AS’ Curve passes through- (Yn , P’).
Conclusion:-
Short Run Medium Run
Prices Increase (small) Increase
Output Increase No change
Interest Rate Increase Increase

(b) Immediate Effect of Tax Reduction on AS Curve:-

Now, if the Income Tax cut affects the Labour Supply-
It will shift AS curve to the right as a reduction in taxes will increase the real
(Disposable) income of the workers. As, we know that there is always a Labour-
Leisure Trade-off. But due to reduction in taxes, Income Effect will be greater than
Substitution Effect [Income Effect > Substitution Effect] and hence the worker will
prefer labour over Leisure and Output will increase. Therefore, AS curve will shift
rightwards.