An increase in taxes through a new budget would
a) shift the aggregate demand right as it rises and increases the Gross Domestic Product at the new equilibrium.
b) shift the aggregate demand left and increase the Gross Domestic Product at the new equilibrium.
c) shift the aggregate demand left and reduce the Gross Domestic Product at the new equilibrium.
d) shift the aggregate demand right as it rises and reduce the Gross Domestic Product at the new equilibrium.
The Correct Answer and Explanation is :
The correct answer is c) shift the aggregate demand left and reduce the Gross Domestic Product at the new equilibrium.
Explanation:
An increase in taxes, especially through a new budget, typically leads to a reduction in disposable income for households and a decrease in after-tax profits for businesses. When individuals and companies have less money to spend or invest, aggregate demand (AD) in the economy falls. Aggregate demand is the total demand for goods and services in an economy, and it is comprised of consumer spending (C), investment spending (I), government spending (G), and net exports (NX).
When taxes rise:
- Consumers have less disposable income because a higher portion of their income is taken by the government in the form of taxes. As a result, they tend to spend less on goods and services. This reduction in consumption leads to a decrease in aggregate demand.
- Businesses may also reduce investment since the higher tax burden could reduce their after-tax profits, making them less likely to expand operations, hire workers, or purchase capital goods.
With lower aggregate demand, the AD curve shifts to the left. As a result of this shift, the overall economic output (Gross Domestic Product or GDP) decreases, leading to a new equilibrium with lower output and potentially higher unemployment.
This process aligns with basic economic principles derived from Keynesian theory, where a decrease in demand due to higher taxes results in a contraction of economic activity, thereby reducing GDP.
An increase in taxes generally does not directly lead to a rise in GDP unless there are compensating factors, such as increased government spending or significant changes in other components of aggregate demand. Hence, the correct answer is c) as the increase in taxes shifts the aggregate demand to the left, resulting in a decrease in GDP at the new equilibrium.
Now, I will generate a visual representation of how aggregate demand shifts left with an increase in taxes.
Here’s the economic graph showing the shift of the Aggregate Demand (AD) curve to the left due to an increase in taxes, which leads to a reduction in GDP at the new equilibrium. This visual representation should help clarify how the increase in taxes affects the overall economy. Let me know if you need any further explanation!