Answer to Question #227792 in Macroeconomics for fatima

Question

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

(a)

An increase in tax rates 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 indicating a negative relationship between interest rate and equilibrium output.

(b)

If government increases income tax, disposable income will decrease in relation to the national income. Hence, 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 reduces the demand for money. If supply of money is fixed, interest rate must fall in order to raise the demand for money and to maintain equilibrium.