Tax Cut and Cheap Inputs
The question
Assume the economy of Merenth is initially in long-run equilibrium. In the same year, the legislature enacts a large cut in the personal income tax households pay, and a record global harvest sharply lowers the prices of the raw materials that firms throughout Merenth use in production. Assume the central bank takes no action and that Merenth's quantity of resources and level of technology are unchanged. Show the short-run effect on Merenth's economy, holding all else constant. Show the effect on the AD-AS Model graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Tax Cut and Cheap Inputs: the worked answer
On the AD-AS Model graph, AD shifts right and SRAS shifts right.
Why AD shifts right and SRAS shifts right
The income tax cut raises households' disposable income, so consumption is higher at every price level and aggregate demand shifts to the right. Independently, cheaper raw materials lower firms' per-unit production costs, so firms are willing to produce more output at every price level and short-run aggregate supply shifts to the right. Neither event changes the quantity of resources or the level of technology, so long-run aggregate supply does not move. Both shifts raise equilibrium output, so real GDP definitely rises. The two shifts pull the price level in opposite directions, because the rightward AD shift raises it while the rightward SRAS shift lowers it, so the change in the price level is indeterminate and depends on which of the two shifts is larger.
What happens to the equilibrium
Real GDP definitely rises, while the price level is indeterminate: it rises if the AD shift is larger, falls if the SRAS shift is larger, and is unchanged if the two are equal.
The mistake students make on this one
The most common error is reporting both outcomes as determinate, almost always as "real GDP rises and the price level rises" because the tax cut is the more familiar shock and students stop reading there. Both shifts do raise output, but they move the price level opposite ways and the stem never says which shift is bigger, so any signed claim about the price level is a guess. A second frequent error is shifting LRAS right for the tax cut, when a change in disposable income alters no resource and no technology.
On exam day
On any combined shift, draw both new curves and then test the two outcome variables separately: if the shifts push a variable the same way, state a direction, and if they push it opposite ways, write the word indeterminate and say it depends on the relative sizes of the shifts.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when AD shifts right and SRAS shifts right and every other curve on the AD-AS Model graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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