Question

If Congress cuts taxes at the same time that businesses become more pessimistic about the economy, what is the combined effect on output, the price level, and employment using the AD/AS diagram?

Short answer

The combined effect of Congress cutting taxes and businesses becoming more pessimistic about the economy on output, price level, and employment, using the AD/AS diagram, leads to an ambiguous change in output and employment, as the tax cut may increase output and employment, while businesses' pessimism may decrease them. However, both factors lead to an increase in the price level.

Step-by-step solution

Understand the AD/AS model

The AD/AS model consists of the Aggregate Demand curve, which shows the total quantity of goods and services demanded at different price levels, and the Aggregate Supply curve, which shows the total quantity of goods and services supplied at different price levels. The intersection of the AD and AS curves shows the equilibrium output, price level, and employment in the economy.

Analyze the effect of a tax cut on AD

When Congress cuts taxes, consumers have more disposable income. This increase in disposable income causes consumption to increase, which in turn causes the Aggregate Demand curve to shift to the right. A rightward shift in the AD curve implies a higher demand for goods and services at the same price level, leading to an increase in output and employment. However, this does not change the pessimistic outlook of businesses yet.

Analyze the effect of businesses' pessimism on AS

When businesses become more pessimistic about the economy, they reduce their investments and production due to the expected lower demand for their products. This leads to a shift in the Aggregate Supply curve to the left. A leftward shift in the AS curve implies lower output, higher price level, and lower employment as firms produce less at each price level anticipating worse economic conditions.

Analyze the combined effect on output, price level, and employment

The combined effect of the tax cut and businesses' pessimism can be analyzed by looking at the new intersection of the AD and AS curves. The rightward shift in the AD curve increases output and employment, whereas the leftward shift in the AS curve decreases output and employment. The result is an ambiguous change in output and employment, depending on the magnitudes of the shifts in the AD and AS curves. However, since both effects lead to a higher price level, we can conclude that the combined effect will result in an increase in the price level. In conclusion, the combined effect of a tax cut and businesses' pessimism leads to an ambiguous change in output and employment, as the increase in output and employment due to the tax cut may be offset by the decrease in output and employment due to businesses' pessimism. However, both factors lead to an increase in the price level.