Answer to Question #218538 in Macroeconomics for lex

Question

Consider two alternative programs for contraction. One is removal of an investment subsidy and the other is the rise in income tax rates. Using the IS-LM model and the investment schedule discuss the impact of these alternative policies on income, interest rates and investment.

Answer 1

1.Removal of an investment subsidy

If investment subsidy is removed, the cost of investment will increase and the investments will decrease. The investment schedule will shift to the left indicating a decrease in investments.

Decrease in investment will result in a decrease in aggregate demand and hence IS curve will shift downwards while LM curve will remain the same. Income will decrease, interest rate will decrease and investment will also decrease.

2.Rise in income tax rates

A rise in income tax rates reduces disposable personal income and hence reduces consumption. The market for economic goods will slow down. Investment schedule will shift to the left because there will be less savings to come up with new investments. The IS curve will thus shift downwards while LM curve will remain the same because the money market will not be affected.

An increase in income tax means that disposable income will decrease, interest rates will decrease in order to boost demand and the rate of investments will also fall because if you pay more taxes before you invest, you will probably have less money to invest into the stock market and other investments.