In a neoclassical economist’s world, an decrease in taxes will

Question

BlackTom AI · Accepted Answer

Neoclassical theory treats long-run output as determined by real factors (labor, capital, technology) and treats money as neutral. Use the quantity equation MV = PY (M = money supply, V = velocity, P = price level, Y = real output). Solving gives P = MV / Y. If M and V are unchanged, P is inversely related to Y: an increase in real output Y reduces P.

Step-by-step reasoning:
1. Tax cuts change after-tax returns to work and saving. Lower taxes raise the after-tax wage and the return to saving, so households supply more labor and save more.
2. Greater saving raises investment and capital accumulation; greater labor supply increases effective labor. Both effects raise potential (long-run) real output Y in the neoclassical model — a rightward shift of the long-run aggregate supply (LRAS).
3. With the money supply M fixed (or not targeted to offset fiscal changes), the increased Y in MV = PY must be accompanied by a lower price level P to restore equilibrium.
4. Therefore, a tax decrease that raises supply-side incentives leads to a higher Y and, given neutral money, a lower P in the neoclassical long run.

Why the correct answer is correct: it follows directly from the supply-side channel (tax cuts boost labor and capital, increasing Y) combined with money neutrality and the quantity theory (P = MV/Y). Increased Y with unchanged M and V implies a lower P.

Why other possible answers would be incorrect:
- “Raise the price level”: that describes a pure demand-driven story; neoclassical long-run focus attributes changes to supply, not persistent demand effects, so price would not rise permanently.
- “Permanently raise output without affecting price”: inconsistent with quantity theory if money is unchanged; higher Y must reduce P.
- “Have no real effects”: Ricardian equivalence would imply neutrality, but neoclassical supply responses (labor/saving) generally produce real effects on Y and therefore affect P.

Conclusion: under neoclassical assumptions, a tax decrease raises real output Y and, with a fixed money supply, lowers the price level P — confirming the correct answer: lower the price level.

In a neoclassical economist’s world, an decrease in taxes willSingle choice

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