| Let's start with the effect of the tax in the labor market.
For any given w/p, the income tax reduces workers' incentives
to supply labor. This shifts the labor supply curve to the left. The effect
on the equilibrium is to raise w/p and lower the equilibrium level
of employment. |
| From the production function, we know that a reduction
in equilibrium employment reduces output. This is a reduction in aggregate
supply. |
| Consider now the AS-AD model in the classical framework.
The Aggregate Demand curve comes from the quantity theory of money: MV=PY
. For any fixed policy choice for the money supply, we can write this
as P=MV/Y, giving a negative relationship between P
and Y (recall that V is assumed to be fixed in the quantity
theory). Thus, if Y goes down because of the labor market tax, the
price level must go up. |
| An intuitive way to think about this is to realize that
for any given level of the money supply, a reduction in output means you
have the same amount of money chasing fewer goods. Because goods have become
scarcer relative to money, the price of goods must go up. |