Explain how an increase in the level of taxation can influence the level of aggregate demand in
an economy?
Aggregate demand is the total demand for a good or service in an economy, at different price
levels.
The factors that affect aggregate demand are investment spending, consumer spending,
government spending, and net exports.
In figure 1 the Aggregate demand curve moves from AD1 to AD2 (a leftward shift); or from
point A to B, which results in the price decrease from PL1 to PL2, and a decrease in the real
GDP from, Y1 to Y2. this causes an increase in unemployment.
An increase in Taxation will cause the aggregate demand to shift to the left (decrease). An
increase in tax will cause a reduction in their disposable income. This will cause a decrease in
consumer spending. Therefore a decline in the purchasing power, hence a decrease in aggregate
demand.
An increase in corporation taxes will also result in, decrease in the after-tax profits for firms.
Hence the firms will reduce their investment spending, which would shift the AD curve to the
left.
The key concept of change can be linked with business and consumer behavior. As the increased
taxes cause a decrease in the consumption of goods and services. Therefore causing a reduction
in aggregate demand and a leftward shift of the AD curve.