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A tax cut that affects both aggregate demand and potential output is predicted to _____ the long-run equilibrium level of output, while inflation _____. Group of answer choicesdecrease; decreasesincrease; increasesincrease; decreasesincrease; may increase, decrease or remain unchanged

Question

A tax cut that affects both aggregate demand and potential output is predicted to _____ the long-run equilibrium level of output, while inflation _____. Group of answer choicesdecrease; decreasesincrease; increasesincrease; decreasesincrease; may increase, decrease or remain unchanged

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Solution

The answer is "increase; may increase, decrease or remain unchanged".

Here's why:

  1. A tax cut can stimulate aggregate demand because it increases disposable income for consumers, allowing them to purchase more goods and services. This increase in demand can lead to an increase in output as businesses produce more to meet this demand.

  2. A tax cut can also affect potential output. By reducing the cost of capital, a tax cut can encourage businesses to invest in new equipment or technologies, which can increase their productive capacity. This can lead to an increase in potential output.

  3. The effect of a tax cut on inflation is less clear and can depend on a variety of factors. If the economy is already at or near its potential output, a tax cut could lead to inflation as increased demand for goods and services outstrips supply. However, if the economy is below its potential output, a tax cut could stimulate output without causing inflation. Additionally, if the tax cut leads to an increase in potential output, this could actually reduce inflationary pressure. Therefore, a tax cut may increase, decrease, or have no effect on inflation.

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