Question

If investment is very interest elastic most of an income tax rate cut will be crowded out therefore central bank should always supplement a tax cut with an increase in money supply”. Comment on this statement with the help of IS-LM diagram and explain the adjustment process. Would your answer change if the price lend were allowed to change. Explain

Answer 1

As interest rates rise and private investment declines, the equivalent of CK's income is erased. Therefore, CK represents the crowding-out effect of the increase in public spending. Therefore, the ISLM model shows that expansionary fiscal policy with increased public spending increases the level of income and interest rates.