Answer to Question #225100 in Macroeconomics for Sara

Question

2. Suppose the government cuts income taxes. Show in the IS-LM model the impact of the tax cut un-
der two assumptions: (1) The government keeps interest rates constant through an accommodating
monetary policy. (2) The money stock remains unchanged. Explain the difference in results.

Answer 1

Situation 1:

• The government keeps interest rates constant through an accommodating monetary policy:

In the above scenario, the term IS-LM model shows the relationship between the interest rate of the economy and money market forces. Shown below is the graphical explanation:

From the above-shown situation, as the government cuts the income taxes and as per the above-shown IS-LM diagram, thus people will generate more income and purchasing power gets to hike and people will have more disposable income and from this, the IS curve will shifts towards the right side from IS to IS1.

Now, when the government keeps the interest rate constant through an accommodating monetary policy, refers to when the Federal Reserve lowers the interest rate in order to hike funds in the economy, and when the government deducts the tax rates, thus this increases the money supply and LM curves shifts rightwards from LM to LM1 and the interest rates get stable to its initial position.

Situation 2:

•  The money stock remains unchanged:

Now, when the money stock remains unchanged but as individual income gets more upwards, thus it increases the money demand in the market as purchasing power increases and it directly increases the interest rate from I to I1 and output also increases from Y to Y1.