Answer to Question #226558 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

a) This will increase demand for money due to the tax cuts.People will have more disposable income , raising the purchasing power and this shifts IS curve to the right from IS to IS1.

b) Individual income increases leading to increase in demand for money as purchasing power increases. Interest rate will rise from I to I1 and output will increase from Y to Y1.

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.