Answer to Question #225807 in Macroeconomics for Deema

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

IS-LM model is a macroeconomic tool that shows a relationship between interest rate and output such that the money market and the product market is in equilibrium simultaneously. Now, if government cuts the income taxes, then the citizens will have higher savings.

(a)

When interest rates are kept constant through an accommodating monetary policy, there will be more investments because consumers will have to save more.

Consumers will save $(1-MPC)$ of the tax cut, so the initial boost in spending will be smaller for change in tax as compared to change in government spending and the IS curve shifts by $\frac {-MPC}{1-MPC} \Delta T$ .

(b)

When money stock remains unchanged, the LM curve does not shift.

When change in money stock is greater than zero, the LM curve shifts to the right causing interest rate to fall which increases investment causing output and input to rise.

Difference

In case (a) keeping interest rates constant through an accommodating monetary policy causes a shift in the IS curve whereas in case (b), where the money stock remaining unchanged , we look at the LM curve.