Answer to Question #212002 in Macroeconomics for Bhavika Chhabra

Question

Assume investment spending is very interest inelastic and money demand is very interest elastic. With the help of IS LM diagram explain the effect of cut in income tax rate on investment spending , money demand, and budget surplus and explain the adjustment process from one equilibrium to another

Answer 1

Solution:

When investment spending is very interest inelastic, it means that the demand for investment is not sensitive to changes in the interest rate. That is, a change in interest rate will result in a small or no change in investment spending.

When the money demand is very interest elastic, it means that the demand for money is very sensitive or responsive to interest rate changes. That is, there will be a significant change in money demand when the interest rate changes.

Income tax rate cuts will increase individual’s disposable income which they can use for more investments. It will also increase the company’s after-tax cash flow, which can be utilized for additional investments. Therefore, investment spending will increase shifting the IS curve to the right, which will raise both the real GDP or income and interest rates.

At the same time, the tax cuts will boost demand by increasing disposable income, hence the demand for money will increase shifting the LM curve to the left, which will reduce the real GDP or income and raise the interest rate.

Income tax cuts will decrease the government revenue resulting in a decrease in budget surplus.

This is demonstrated by the below IS-LM diagram:

The adjustment process involves utilizing a mix of both fiscal and monetary policies such as increasing money supply, interest rate cuts, and increased government spending to bring about a balance in the economy, which will shift the equilibrium to a balanced equilibrium point.