Macroeconomic as/Ad Framework

1) Use the AS/AD framework to show the separate effects on GDP, inflation and public sector borrowing on any single national economy of: a) cut in public spending b) an increase in the rate of VAT (sales tax) c) a slowdown in the GDP growth of less developed economies. (Make sure that you include clear and appropriate diagrams for this question) According to Begg and Ward (2009) fiscal policy is the government’s decisions regarding taxation and spending to influence level of demand for goods and services. Cut in public spending and increase in the rate of VAT are instruments of contractionary fiscal policy in order to slow down economy, reduce inflation and deficit. a) Cut in public spending (cut of public work projects, defence, health care,etc.) results in fall of aggregate demand (AD=C+I+G+NX), decrease in price level, reduction in companies output and their workforce. National output will be decreased and since the gap between government income and spending (budget deficit) reduces, government will reduce borrowing. b) Increase in rate of VAT leads to reduction of disposable income. Since consumers will have less money they reduces consumption (component of aggregate demand) and results in decrease and shift of aggregate demand curve to the left. In that way demand pull inflation starts to decrease as well as output. As an unpleasant effect, unemployment rate starts to increase, however because of increased government income from taxes, budget deficit reduces as well as need for borrowing. For simplicity AS and AD curves will be represented under the Keynesian Cross approach as linear functions described in Begg and Ward(2009). Graphically both effects looks the same, equilibrium level will decrease from Y1 to Y2 and price level will decrease from P1 to P2, aggregate demand will shift to the left.
Price

AS

P1 P2 AD1 AD2

Both effects

Bibliography: 1) David Begg and Damian Ward (2009). Economics for Business. 3rd edition  2) UNDP ‐ Globalization, Agriculture and the Least Developed Countries ‐ Making Globalization  Work for the LDCs ‐ Istanbul, July 2007  3) Eurostat Newsrelease Euroindicators 62/2012  ‐  23 April 2012  4) Croatian National Bank ‐ REGULAR PUBLICATIONS ‐ Information on economic trends ‐  STANDARD PRESENTATION FORMAT 2nd quarter 2012