Suppose there is full employment and aggregate supply is vertical. A decrease in taxes:

Question

Accepted Answer

The correct option is 3: increases the price level but has no effect on real output.

In macroeconomic analysis, the assumption that "aggregate supply is vertical" implies that the economy is operating at its maximum potential output, or the Long-Run Aggregate Supply (LRAS) curve. The condition of "full employment" confirms this point, meaning all available resources are fully utilized, and real output (Real GDP) cannot be increased further, regardless of price changes. A decrease in taxes is a form of expansionary fiscal policy. Lower taxes increase disposable income for households and/or profitability for firms, leading to an increase in consumption and investment spending, thus shifting the Aggregate Demand (AD) curve to the right. Since the Aggregate Supply curve is vertical (meaning output is fixed at the full employment level), the increased Aggregate Demand cannot lead to greater production. Instead, this excess demand causes competition for the fixed supply of goods and resources, which only results in bidding up the overall price level, causing inflation without changing the real output.

The incorrect option is 1: has no effect on the price level or real output.
This is incorrect because a decrease in taxes is an expansionary policy that shifts the Aggregate Demand curve rightward, which will always put upward pressure on the price level when the AS curve is vertical.

The incorrect option is 2: increases real output but has no effect on the price level.
This is incorrect because real output is fixed at the full employment level when the AS curve is vertical. An increase in real output would only be possible if the AS curve were upward-sloping (short run) or shifted rightward. Furthermore, the increase in AD would lead to a price increase.

The incorrect option is 4: increases the price level and real output.
This is incorrect. While the price level increases due to the rightward shift in AD, the real output remains constant because the vertical aggregate supply curve signifies the maximum, fixed potential output of the economy.