ECON 1BB3 Lecture Notes - Money Supply, Monetary Policy, Fiscal Policy

If the economy adjusts through the automatic mechanism, then a decline in aggregate demand causes: 

 

(i) an expansion in the short run and an increase in the price level in the long run. 

(ii) a recession in the short run and an increase in the price level in the long run. 

(iii) an expansion in the short run and a decline in the price level in the long run. 

(iv) a recession in the short run and a decline in the price level in the long run. 

We know that when an economy starts out at long-run equilibrium and the government cuts taxes, this will result in inflation in the long run. What happens if the economy is producing a level of output below the full employment (long-run equilibrium) level and the government cuts taxes?