Fiscal Policy (AD-AS) drawing worksheet
The answer key prints on its own page, so hand out everything before it.
Fiscal Policy (AD-AS) drawing worksheet · problem 1 of 4
Assume the economy of Tarnholm is currently producing below its full-employment level of output. The legislature of Tarnholm passes a large highway construction program and immediately awards contracts to private firms, which begin paving and bridge work this year. Assume the central bank takes no action and that none of the new roads will carry traffic for several years. Show the effect of this program on Tarnholm's economy this year, holding all else constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Fiscal Policy (AD-AS) drawing worksheet · problem 2 of 4
The economy of Vireska has been growing rapidly and prices are climbing quickly. Vireska's legislature raises the personal income tax rate paid by households, reducing the take-home pay families have available each month. Assume the central bank takes no action and that nominal wages set in existing labor contracts do not change. Show the effect of this policy on Vireska's economy in the short run, holding all else constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Fiscal Policy (AD-AS) drawing worksheet · problem 3 of 4
The government of Halvern, needing new revenue, begins charging firms a tax of a fixed dollar amount on every unit of output they produce. The tax is collected from the firms themselves, and a firm owes it on each unit whether or not that unit earns a profit. Assume the central bank takes no action. Show the short-run effect of this tax on Halvern's economy, holding all else constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Fiscal Policy (AD-AS) drawing worksheet · problem 4 of 4
The economy of Cassaria has entered a downturn and layoffs are spreading. Under a program already written into law, every worker who loses a job automatically begins receiving unemployment benefit payments from the government, and total benefit payments across Cassaria climb sharply without any new vote by the legislature. Assume the effect of the layoffs themselves is already reflected in the graph as drawn. Show only the additional effect of these benefit payments on Cassaria's economy this year, holding all else constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Fiscal Policy (AD-AS) drawing worksheet: answer key
1. Highway Program in a Recession: ad shifts right
Government purchases of goods and services are a component of aggregate demand, and paying private firms to pave roads and build bridges is a purchase of goods and services in the current year. Total spending is higher at every price level, and the construction wages that workers receive and respend multiply that initial increase, so aggregate demand shifts to the right. None of the roads can carry traffic for several years, so the economy's resources and technology are unchanged and long-run aggregate supply does not move. Firms' per-unit production costs are untouched, so short-run aggregate supply stays put.
The equilibrium price level rises and real GDP increases, moving output back toward full employment and shrinking the recessionary gap.
Watch for: The tempting second shift here is long-run aggregate supply, because a highway is public capital and capital sounds like capacity. Capacity moves only once that capital is finished and carrying traffic, which the stem puts several years out, so nothing Tarnholm spends this year changes its resources or technology. Shifting LRAS now also widens the recessionary gap instead of closing it, because potential output slides right while actual output stays where aggregate demand put it.
2. Household Income Tax Increase: ad shifts left
A higher personal income tax rate lowers households' disposable income, and with less take-home pay households consume less at every price level. Consumption is the largest component of aggregate demand, so aggregate demand shifts to the left, and the tax multiplier magnifies the initial cut in spending, though by less than a spending multiplier because part of the tax is paid out of saving rather than consumption. The tax falls on household earnings, not on units of output, and nominal wages are fixed by contract, so short-run aggregate supply does not move; resources and technology are unchanged, so long-run aggregate supply stays put.
The equilibrium price level falls and real GDP decreases.
Watch for: A very common wrong answer shifts short-run aggregate supply to the left, because a tax feels like a cost and students remember that higher costs move SRAS. This tax is levied on what households earn, not on each unit a firm produces, so no firm's per-unit cost changes. The SRAS drawing also predicts a rising price level, which is the opposite of what a policy designed to cool inflation is supposed to do, so it fails its own sanity check.
3. Per-Unit Tax on Producers: sras shifts left
A tax charged on each unit produced is part of what it costs a firm to bring that unit to market, so per-unit production costs rise for firms across the economy. At every price level the total output firms choose to produce is smaller, which shifts short-run aggregate supply to the left. The tax is not a government purchase, a transfer, or a change in households' take-home pay, so no component of aggregate demand moves. The economy's quantity of resources and its level of technology are unchanged as well, so long-run aggregate supply stays where it is.
The equilibrium price level rises while real GDP falls, which is stagflation, and output ends up even further below the full-employment level marked by LRAS.
Watch for: The common wrong answer shifts aggregate demand left, because a tax sounds like less money circulating and the personal income tax students meet most often does move that curve. What the tax is charged on decides which curve moves: this one is charged on each unit a firm produces, so it enters the model as a per-unit cost, while an income tax is charged on what households earn and works through disposable income. The aggregate demand answer also predicts a falling price level, and a tax on every unit produced pushes the price level up.
4. Benefits Rise as Layoffs Spread: ad shifts right
Unemployment benefits are transfer payments, so they are not counted in government purchases, but they hand disposable income to households that have just lost their wage income and those households spend a large share of every dollar they receive. Higher consumption at every price level shifts aggregate demand to the right, and the multiplier carries that spending through the economy just as a tax cut would. No firm's per-unit production cost changes and the economy's resources and technology are unchanged, so short-run and long-run aggregate supply both stay put.
The price level and real GDP are both higher than they would otherwise be, so the recessionary gap the downturn is opening ends up smaller than it would have been without the payments.
Watch for: Many students shift aggregate demand left, reading the stem as a recession question and drawing the layoffs a second time. The layoffs are already in the graph by assumption, and the change being asked about is the benefit expansion, which puts spendable income back into households' hands and pulls aggregate demand toward the right. Others leave the graph untouched because transfers are not part of government purchases; transfers still reach aggregate demand through the consumption they finance.