Friday, May 14, 2010

We did this essay in class the other day:

Using an appropriate diagram, explain how a government decision to decrease income tax rates could lead to a movement along the short-run Phillips curve. [Nov 09, 5]

I have posted the ideas discussed in my wikispaces site for any interested IB Economics (higher level) candidate to look at. If you are not my student, please keep in mind that what your own instructor expects is more important.

There are many ways to tackle this question. One could start off by mentioning that taxes can be distinguished into direct (e.g. taxes on income, on profits, on wealth) and indirect (taxes on goods and on expenditures).

You would then explain that a decrease in income tax rates would increase disposable income (defined as income minus direct taxes plus transfer payments). Consumption (spending by households on durables, non-durables and services per period) is thus expected to increase and, since consumption expenditures are typically a large component of aggregate demand (total spending per period on domestic output), AD is expected to increase and to shift to the right from AD1 to AD2 (you should, in my opinion include a simple AD/AS diagram):

(the rest of the stuff is found here)