Answer to Question #226561 in Macroeconomics for Sara

Question

1. The following equations describe an economy. (Think of C , I , G , etc., as being measured in
billions and i as a percentage; a 5 percent interest rate implies i = 5.)
C 5 0.8(1 2 t ) Y (P1)
t 5 0.25 (P2)
I 5 900 2 50 i (P3)
−−G 5 800 (P4)
L 5 0.25 Y 2 62.5 i (P5)
−−My−
P 5 500 (P6)
3. a. 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

3 a)

Increase in tax rates increases the prices of goods and services which subsequently leads to a decrease in demand for those products and services. This leads to the shift of the IS curve to the left.

b)

Increase in the tax rate affects the disposable income of consumers and the national income. Increase in tax rates reduces the amount of disposable income of consumers in relation to the national income. Therefore the consumption rate of consumers reduces drastically. Thereby reducing the equilibrium level of income altogether.

c)

When tax rates increase the Consumption of various products and services substantially goes down, causing a decrease in equilibrium output and income income. Substantial decrease in income reduces greatly the demand for money. Since money supply is fixed or constant, the interest rate decreases to influence and increase in the demand for money so as to maintain the market equilibrium.