Suppose the government announces a tax reduction. With an aid of AS-AD diagram, suggests a demand-side factor to offset the effect on the price level. Explain

Usually, when we talk about offsetting the effect on demand side, we would consider fiscal policy adopted by the government.

When there is a tax reduction, the disposable income increases, so the consumption expenditure increases, and thus the aggregate demand increases. The price level will increase and the output level will also increase. This creates an inflationary gap. If the government reduces government spending in the long run, the aggregate demand decreases. The price level and the output level will restore to their original level.