Question

Review the problem in the Work It Out titled "Interpreting the AD/AS Model." Like the information provided in that feature, Table 10.2 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. \begin{equation}\begin{array}{c|c|c}\hline \text { Price Level } & \text { AD } & \text { AS } \\\\\hline 110 & 700 & 600 \\\\\hline 120 & 690 & 640 \\\\\hline 130 & 680 & 680 \\\\\hline 140 & 670 & 720 \\\\\hline 150 & 660 & 740 \\\\\hline 160 & 650 & 760 \\\\\hline 170 & 640 & 770 \\ \hline\end{array}\end{equation} a. Plot the AD/AS diagram from the data. Identify the equilibrium. b. Imagine that, as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level. Identify the new equilibrium. c. How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment?

Short answer

The new equilibrium, after considering the government tax cut and increase in aggregate demand by 50 at every price level, is at a price level of 140 and an output level of 720. Comparing this to the original equilibrium (price level 130, output 680), we can see that output has increased by 40, the price level has increased by 10, and it is likely that employment will also increase due to increased demand for labor as firms produce more goods and services.

Step-by-step solution

Plot the AD/AS diagram and identify the equilibrium

First, we need to plot the aggregate demand (AD) and aggregate supply (AS) curves on a price level (Y-axis) and output level (X-axis) graph based on the given data points. The equilibrium is where the AD curve intersects the AS curve. This is the point where the quantity demanded equals the quantity supplied. In our case, we can see that the equilibrium point is at a price level of 130 and an output of 680.

Consider the effect of government tax cut on aggregate demand

Now, we assume that the government implements a tax cut, which in turn causes an increase in aggregate demand. According to the problem, the aggregate demand becomes higher by 50 at every price level, so we must adjust our AD curve. Add 50 to each aggregate demand value in the table and you will get the following updated data points: Price Level: 110, New AD: 750 Price Level: 120, New AD: 740 Price Level: 130, New AD: 730 Price Level: 140, New AD: 720 Price Level: 150, New AD: 710 Price Level: 160, New AD: 700 Price Level: 170, New AD: 690 Now, plot the new AD curve with these updated data points on the same graph.

Identify the new equilibrium and study its effects

The new equilibrium is the point where the updated (shifted) AD curve intersects the original AS curve. From the graph, we can see that the new equilibrium is at a higher price level of 140 and an output level of 720. Comparing the new equilibrium to the original one, we can see that: a) Output has increased from 680 to 720 due to the increase in aggregate demand. b) The price level has increased from 130 to 140. c) Since output has increased, it is likely that employment will also increase as firms produce more goods and services, leading to an increased demand for labor. This concludes our analysis of the Xurbia AD/AS model, including the effects of government tax cuts on aggregate demand, output, price level, and employment.

Key concepts

Aggregate Demand and Supply

Understanding the interactions between aggregate demand (AD) and aggregate supply (AS) is fundamental to grasping macroeconomic analysis. Aggregate demand represents the total quantity of goods and services that households, businesses, and the government are willing and able to purchase at various price levels. Conversely, aggregate supply reflects the total production that producers are prepared to offer at different price levels.

When representing these concepts graphically, the AD curve typically slopes downward, indicating that at lower price levels, more goods and services are demanded. The AS curve can slope upwards in the short-run, showing that higher price levels incentivize producers to increase supply. However, the AS curve is vertical in the long-run, representing the economy’s maximum sustainable output.

The interaction of AD and AS curves on a graph models the behavior of the economy and helps in anticipating changes in output and price levels upon economic shocks such as tax changes or global events.

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs at the intersection of the AD and AS curves, where the quantity of goods and services demanded equals the quantity supplied. This equilibrium results in a specific output and price level that represents the economy's status at a given point in time.

The initial equilibrium in the given exercise is identified at a price level of 130 with an output of 680. An understanding of this equilibrium is crucial as it serves as a reference point for predicting the economic impact of various policy interventions. The equilibrium is a dynamic point that can shift due to changes in either AD or AS, and analyzing these shifts is a key part of macroeconomic analysis.

Government Tax Cuts Impact

Government policy, such as tax cuts, can profoundly influence aggregate demand. Tax cuts increase households' disposable income, allowing them to spend more on goods and services. This surge in consumption drives up aggregate demand.

In the exercise, a hypothetical government tax cut results in AD increasing by 50 at every price level. This shifts the AD curve to the right, indicating a higher quantity demanded for goods and services at each price level. Such a policy change does not occur in a vacuum – it interacts with other economic factors, such as the elasticity of AS and the existing fiscal stance. The precise effects depend on the broader economic context and the capacity of the economy to respond to increased demand.

Output and Price Level Changes

The increase in AD from the government tax cut leads to a new macroeconomic equilibrium. As aggregate demand rises, the economy moves to a higher output and price level. In the exercise, output increases from 680 to 720, and the price level climbs from 130 to 140.

This change in output indicates economic growth, likely leading to more robust employment as firms hire to meet the higher demand. However, the increased price level, known as inflation, can erode consumer purchasing power if wages do not adjust correspondingly. Policymakers must therefore strike a balance: fostering growth through stimuli like tax cuts while being wary of excessive inflation that could destabilize the economy.