Answer to Question #211657 in Macroeconomics for NARTEY SAMUEL

Question

The following equations describe an economy (think of C, I, G, etc as being measured in billions and i as a percentage; a 5 percent interest rate implies i = 5) 

C = 0.8 (1 – t) Y

t = 0.25

I = 900 – 50i

G = 800

L = 0.25Y – 62.5.i

M / P = 500

1. How does an increase in the tax rate affect the IS curve?

How does the increase affect the equilibrium level of income?

2. Show that a given change in the money stock has a larger effect on output the less interest sensitive is the demand for money.

(b) How does the respond of the interest rate to a change in the money stock depend on the interest sensitivity of money demand?

Answer 1

a) Tax increase shifts IS curve. The LM curve remains unchanged, and the economy moves along the LM curve. When taxes increase: consumption falls, resulting in a decrease in production/income

With an increase in taxes, consumption decreases, contributing to a income or Production decrease in production. The decrease in income minimizes the demand for money. As money supply becomes fixed, interest rates must fall to drive the demrates of interest fall in terms of driving and maintaining equilibrium.

2b)

Increasing Y increases the demand for money. If the demand for money is extremely sensitive to interest rates, then the rate of increase in interest rates is small, the demand for money will decrease, and the money market will return to equilibrium.