Answer to Question #285255 in Macroeconomics for Rosa

Question

Consider two alternative programs for contraction.One is the removal of an investment subsidy;the other is a rise in income tax rates. Use the IS-LM model and the investment schedule ,as shown in Figure 11-9 ( Dornbusch Fischer ) , to discuss the impact of these alternative policies on income , interest rates ,and investment.

Answer 1

IS curve showing inverse relation between interest and output. It is showing goods market in equilibrium. While the LM curve showing direct relation interest and output LM curve showing money and asset market in equilibrium.

The removal of investment subsidy is showing in below diagram 1, as without investment subsidy investment is 1, interest rate is also I and IS-LM model is in equilibrium at point E with interest rate I and output level Y after investment subsidy investment schedule shift to I, with 1, Investment and I, Interest rate at point E, With this change iS curve also shifting to IS, and equilibrium point is E, with Y, output and i, interest rate. If now remove the investment subsidy then investment schedule shift back to 1 with investment amount I and interest rate. This result in shift back IS curve to iS with output level Y and I interest rate at point E. So this removal of subsidy put investment, output and interest rate back to without subsidy level at equilibrium point as output level

Rise in income tax rate affects disposable income and multiplier value. It reduces disposable income and increase in tax reduces multiplier value and so affect the slope of IS curve. As fall in multiplier means increase in slope of 15 or steeper the slope of IS curve it is showing in below diagram-2 without tax adjustment equilibrium is at point E with interest rate I and output Y. As income tax rate increases then IS shift leftward and steeper too with E, as equilibrium level, I, as interest rate and Y, as output level.

Conclusion: Removal of an investment subsidy is better than income tax because it reduces output but not less than without investment subsidy case. While an increase in income tax reduces output more than alternative program