Answer to Question #285253 in Macroeconomics for Free

Question

Suppose the government cuts income taxes.Show in the IS-LM model the impact of the tax cut under two assumptions:a)The government keeps interest rates constant through an accomodating monetary policy.b) The money stock remains unchanged .Explain the difference in results.

Answer 1

a) A tax cut reduces the income tax available for a nation which implies a fiscal policy. The IS Curve will become flatter since a fall in income tax increases the multiplier. Since the interest rate is kept constant it will remain constant but the output will increase and thus push the equilibrium level to a new point from point E to E2 and income from Y to Y2.

b) If government cuts taxes and keeps money stock constant, the interest rate will increase as well as output in the economy. The interest rate will increase from i to i1 and output from Y to Y1. The equilibrium E to E1.

The difference is that when the interest rate is held constant, it leads to expansionary monetary policy while when money stock is held constant it leads to high interest rate and high output at equilibrium.