An Income Tax Cut Lifts Consumption
Lower income taxes raise disposable income and consumer spending, shifting AD right and opening an inflationary gap.
An Income Tax Cut Lifts Consumption
AD-AS ModelLower income taxes raise disposable income and consumer spending, shifting AD right and opening an inflationary gap.
Equilibrium at Real GDP (Y) 80, Price Level (PL) 60
Long-run equilibrium
The economy starts in long-run equilibrium, where AD meets SRAS on LRAS. Real GDP is at the full-employment level and the price level is stable.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
An Income Tax Cut Lifts Consumption, step by step
- 1
Long-run equilibrium
The economy starts in long-run equilibrium, where AD meets SRAS on LRAS. Real GDP is at the full-employment level and the price level is stable.
- 2
Disposable income rises, consumption (C) climbs
Lower income tax rates leave households more of what they earn. Higher disposable income raises consumer spending (C), which is the AD determinant at work here. Total spending is higher at every price level, so AD shifts right. Households save part of the tax cut and spend the rest, so the initial rise in spending is smaller than the cut itself. The tax multiplier then magnifies what they do spend, which is why a tax cut shifts AD by less than a government spending increase of the same dollar size.
- 3
An inflationary gap opens
AD now crosses the unchanged SRAS at a higher price level and at a real GDP above the full-employment level marked by LRAS. Output above potential is an inflationary gap, and the price increase is demand-pull inflation because the spending side moved. Unemployment falls below its natural rate.
- 4
Beyond what the graph shows
This is expansionary fiscal policy, and the graph stops where an exam answer stops: at the short-run gap. In the long run, the overheated labor market would push wages up, shift SRAS left, and return output to full employment at a higher price level. The deficit financing also raises the real interest rate in the loanable funds market. Neither of those effects is drawn here.
Where it ends up
An income tax cut raises consumption, shifting AD right, so the price level rises and real GDP rises above full employment, leaving an inflationary gap.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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