Answer to Question #225933 in Macroeconomics for Mira

Question

How does an increase in the tax rate affect the IS curve?
b. How does the increase affect the equilibrium level of income?
c. How does the increase affect the equilibrium interest rate?

Answer 1

(a)

An increase in tax rate results in a drop in investment which pushes down the demand for goods. The equilibrium level of output is lower. The IS curve slopes downwards representing a negative relationship between interest rate and equilibrium output.

(b)

If government increases income tax, then disposable income drops in relation to national income. Thus consumption also falls at every level of national income. The result of this shift is a fall in equilibrium national income.

(c)

When taxes increase, rate of consumption falls leading to a decrease in output and also income. The decrease in income declines the demand for money. If supply of money is fixed, interest rate must fall in order to rise the demand for money and maintain equilibrium.