Consider an economy that begins with output equal to its natural level. Suppose the government enacts a decrease in income taxes (e.g. the 2001 Bush tax cuts).
Explain the meaning of the natural level of output.
Use the AD-AS and IS-LM models to show the short-run and medium-run effects of the policy change on the AD, AS, IS, and LM curves. Be sure to show the feedback to the LM curve from the changes in the price level.
Summarize the effects on output, interest rates, and the price level in both the short run and the medium run.
What is the impact on consumption and investment in the medium run?