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An economy is currently in equilibrium, where aggregate demand (AD) is equal to aggregate supply (AS), resulting in an equilibrium price level and equilibrium GDP.

Using the AD-AS approach, analyze the impact of the following independent events/situations on the equilibrium price level and equilibrium GDP:

1. Assume that India becomes Covid-19 free in the first week of February 2022, and all Covid-19-related restrictions imposed by the Central and State governments are lifted with effect from 7th February 2022.

2. The Government of India increases personal income tax and corporate income tax. At the same time, crude oil prices increase drastically.

(Note: Your answer to each event/situation must be independent of the others.)

Answer :

There are two events that have been asked to analyze in this question. Both of them have an impact on the equilibrium price level and equilibrium GDP of an economy that is currently in equilibrium.

Let's analyze them one by one.

1. India becoming Covid-19 free in the first week of February 2022 and all the Covid-19 related restrictions imposed by the Central and State governments will be lifted with effect from 7th February 2022. Impact on the equilibrium price level and equilibrium GDP:

The lifting of Covid-19 related restrictions and India becoming Covid-19 free will lead to an increase in aggregate demand.

This is because people will start spending more money and businesses will increase their production as there are no restrictions on them anymore. This increase in aggregate demand will lead to an increase in both the equilibrium price level and equilibrium GDP.

2. Government of India increases personal income tax and corporate income tax. At the same time, crude oil prices increase drastically. Impact on the equilibrium price level and equilibrium GDP:

The increase in personal income tax and corporate income tax will lead to a decrease in disposable income. This decrease in disposable income will lead to a decrease in consumption expenditure which in turn will lead to a decrease in aggregate demand. This decrease in aggregate demand will lead to a decrease in both the equilibrium price level and equilibrium GDP.

On the other hand, the drastic increase in crude oil prices will lead to an increase in production costs for businesses. This will lead to a decrease in short-run aggregate supply. The decrease in short-run aggregate supply will lead to an increase in the equilibrium price level and a decrease in equilibrium GDP.

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