Question

A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?

Short answer

In the AD/AS model, tax cuts increase disposable income, leading to higher consumption and investment, resulting in increased aggregate demand. This causes a rightward shift of the AD curve (from AD to AD') in the diagram. The new equilibrium occurs where the AD' curve intersects the AS curve, typically resulting in a higher output level (real GDP) and possibly a higher price level. If this increase in output moves the economy out of the recessionary gap, tax cuts can be said to have led the economy out of the recession. The AD/AS diagram effectively demonstrates this process.

Step-by-step solution

Understand the AD/AS Model

The AD/AS Model is a macroeconomic model that helps explain the relationship between output (real GDP) and the price level in an economy. The model consists of two curves: Aggregate Demand (AD) curve, which shows the relationship between the price level and the quantity of real output demanded, and Aggregate Supply (AS) curve, which shows the relationship between the price level and the quantity of real output supplied by producers.

Identify the initial equilibrium

In the AD/AS diagram, the point where the AD curve intersects the AS curve represents the initial equilibrium. At this point, the quantity of goods and services demanded is equal to the quantity supplied, resulting in an equilibrium output level and an equilibrium price level.

Understand the impact of tax cuts

Tax cuts, in general, increase the disposable income of individuals and businesses, which in turn results in higher consumption and investment. As a result, tax cuts lead to an increase in Aggregate Demand.

Shift the Aggregate Demand curve

Due to the tax cuts, there is an increase in Aggregate Demand. This is represented by a rightward shift of the AD curve on the AD/AS diagram. This new curve, AD', represents the increased demand for goods and services in the economy as a result of lower taxes.

Identify the new equilibrium

After the tax cuts, the AD curve shifts to AD'. The new equilibrium is now at the point where this new AD' curve intersects the AS curve. This new equilibrium typically results in a higher level of output (real GDP) and possibly a higher price level, depending on the slope of the AS curve.

Analyze the impact on the economy

The increase in output (real GDP) due to tax cuts can be interpreted as an improvement in the overall economic situation. If this increase in output is sufficient to move the economy out of a recessionary gap (where the initial output level was below the potential output of the economy), it can be said that the tax cuts have led the economy out of the recession. In conclusion, we can use the AD/AS diagram to show how tax cuts lead an economy out of a recession by increasing aggregate demand, shifting the AD curve, and leading to a new equilibrium with a higher output level. This increase in output, if substantial enough, can help the economy recover from a recession.