Question #2
Suppose the economy begins with output equal to its natural level. Then there is a
reduction in income taxes.
a.
With the reduction in the income tax, we observe from the graph that an increase in the
aggregate demand results in an increase in the price level.
In this situation the IS-LM relation moves in tandem with the AS-Ad relation. With a
decrease in taxes, the IS curve shifts upward. This causes the AD curve to shift upward as
well, leading to a higher price level. Remember that when the IS curve shifts upward, the
interest rate increases which is what leads to the higher price level.
In the long run the output will return to its natural level. When the AD curve shifts upward
it causes the output to increase beyond its natural level. In the long run, on the new AD
curve, the price level must increase until the output returns to the natural level.
b.
In the medium run, the interest rate returns to the natural level. Also in the medium run the
output returns to the natural level. However, due to the new AD curve, the price level
increases until the output returns to the natural level. As the output decreases from an
above natural level to the natural level, both investment and consumption will decrease.
Problem #7
a.
When the interest rate increases above zero, the slope of the LM curve also increases
