Effect of Increased Taxation on Aggregate Demand and Aggregate Supply

The economy, just as is the case of markets, has two forces – the demand forces and the supply. In case of the economy, the demand is denoted as aggregate demand (AD) and represents the quantity demanded (goods and services) in the economy at varying price levels (Arnold, 2008, p. 156). Graphically, AD curve slopes towards the right since as price levels fall, individuals can purchase more goods and services with their income thus increasing the quantity demanded. The supply side of the economy is denoted as aggregate supply (AS). In the short-run, the aggregate supply curve (SAS curve) is upward sloping. The SAS curve represents how, in the short run, alteration of AD influences price level and real output (Colander, 2008, p.212). Thus, the SAS curve depicts that an increase in the output, resulting from increased AD, leads to a rise in price level – thus the upward sloping curve.

A third aspect of the AD-AS model is the long run aggregate supply curve (LAS curve), which represents the relationship between output and price level in the long term (Colander, 2008, p.213). Unlike the SAS curve, the LAS curve is vertical because it is evaluates the price level according to the potential output (i.e. output level at which labor and capital are fully employed) (Colander, 2008, p.213). This implies that any rise in prices corresponds to equivalent increase in the price of inputs such as wages and vice versa. Accordingly, if all prices increased at the same rate, the real incomes would remain the same hence the AD would not change; the the potential output will not be sensitive to changes in prices. Shifts in the LAS curve will thus occur only when potential output changes. Potential output changes result from changes in aspects such as capital, technology and available resources (Colander, 2008, p.214).

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