Answer to Question #296567 in Macroeconomics for Harender Singh

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?

Answer 1

a. An increase in the tax rate, all else constant, affects the IS curve by shifting it to the right because taxes effectively decrease demand for goods and resultantly decrease consumption.

b. An increase in tax rate affects the equilibrium level of income by reducing the interest rate. When taxes increase, consumption reduces thus resulting to a decrease in income. A decrease in income reduces the demand for money. Given that the money supply is fixed, the interest rate must decrease to push up demand for money and maintain the equilibrium.