Consider a closed economy. Using the IS-LM and AD-AS models, show graphically how a simultaneous increase...

Consider a closed economy. Using the IS-LM and AD-AS models, show graphically how a simultaneous increase in taxes and a decline in government spending would affect equilibrium output, interest rates, unemployment rate, and the price level both in the short-run and medium-run.

Next, explain the effects (if any) using a time-series graph on the consumption and investment both in the short-run and medium-run.

Suppose that the economy starts at the natural level of output. Please label the initial equilibrium with the letter A, the short-run equilibrium with the letter B, and the medium-run equilibrium with the letter C.

Expert Solution

An increase in tax and a decline in government spending lead to IS curve shifting to the left. It denoted reduction in aggregate demand(fall in consumption and government spending), so AD curve also shifts left. Due to this, interest rates and output in economy fall immediately in the short run, due to which unemployment level and price level also falls:

However, since the price level has fallen down, effective money supply(M/P), increases, which shifts the Lm curve slightly to the right. This leads to further reduction in interest rate. This substantial fall in interest rate allow investors to undertake investment spending, which raises output for the economy over time. Therefore, AD curve shifts a little to the right. So, in the medium run, output increase slightly, which also increases the unemployment and price level(although levels are still below the initial levels) and a further reduction in interest rates:

In the short run, both consumption and investment fall sharply, due to reduction in output level. However, over the time, both starts increasing. Compared to consumption, investment level grow higher because of lower interest rate and increasing output. Consumption also rises over time as a result of increased output,, but its level remains much below the initial ones. Due to lower interest rate, we can say that composition of output in the economy changes in the favor of investment:

All the relevant points are marked in the diagram below:

Rahul Sunny answered 8 months ago

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