<p>By using aggregate supply and demand curves to illustrate your points, discus

Question

<p>By using aggregate supply and demand curves to illustrate your points, discuss the impacts of the following events on the price level and on equilibrium GDP (Y) in the short run:<br />1) a tax cut holding government purchases constant with the economy operating at near full capacity<br />2) an increase in the money supply during a period of high unemployment and excess industrial capacity<br />3)an increase in the price of oil caused by a war in the Middle East, assuming that the Fed attempts to keep interest rates constant by accommodating inflation&#160;<br />4) an increase in taxes and a cut in government spending supported by a cooperative Fed acting to keep output from falling&#160;</p>

Explanation / Answer

By using aggregate supply and demand curves to illustrate your points, discuss the impacts of the following events on the price level and on equilibrium GDP (Y) in the short run:

1) a tax cut holding government purchases constant with the economy operating at near full capacity

A tax cut increases the consumer disposable income, which increases the spending, this will cause a shift in the AD curve towards its right, this will lead to rise in the equilibrium point resulting a price level increase, and equilibrium real GDP will also increase.

This effect may lead to demand pull inflation

2) an increase in the money supply during a period of high unemployment and excess industrial capacity.

This is the situation of recession, when the money supply is increased than there will be a decrease in the interest rate, this will make the loans and investment cheaper.

Due to lowered interest rates, the rate of return on a project will be higher making the companies to invest more, this leads to higher employment rate.

The overall effect is the AD curve shifts towards its right, decreasing the recessionary GAP.

3)an increase in the price of oil caused by a war in the Middle East, assuming that the Fed attempts to keep interest rates constant by accommodating inflation.

Due to decrease in the oil supply the Short Run Aggregate Supply curve will shift towards its left, this will make a rise in price level and consequently inflation.

This decrease the Aggregate demand, so to combat it FED tries to maintain constant interest rates to boost the investments, this will ensure growth and employment, otherwise the country will be pushed into recession resulting a cyclical unemployment due to reduced demand because of inflation.

4) an increase in taxes and a cut in government spending supported by a cooperative Fed acting to keep output from falling.

When there is demand pull inflation, the economy will be heated up as it operates at a level above the potential GDP. To bring down the economy the government will adopt a contractual fiscal policy, by increasing the taxes and decreasing the government spending, this will shift the AD curve towards its left bring back the economy at potential level of GDP.

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