Answer to Question #191332 in Macroeconomics for abdullah

Question

 Explain what happens to consumption, investment, and the interest rate when the government increases taxes. Show graphically the effect of increased taxes when saving is not dependent on interest rate. 

Answer 1

When the government raises taxes, families have less money to spend. Tax increases result in a drop in consumption.

Increased taxes, which resulted in a drop in spending, must be followed by a rise in investment, but this requires lowering interest rates as well. As taxes are raised, consumption falls, resulting in a drop in output/income. The demand for money is reduced as income falls. Given that the supply of money is fixed, the interest rate must fall in order to preserve equilibrium by increasing the demand for money.

Therefore there is fall in consumption and interest rates followed by increase in investment due to increase in taxes.

Increase in taxes lead to fall in consumption. As these components fall, the AD curve will move back to the left.