Question

Analyze the effect of the following events on the economy. Make sure to explain everything step-by-step. The example is provided in the first task.

a) The central bank increases the money supply.

Ms increases => interest rate decreases => investment increases =>Y increases

On the graph: LM shifts to the right; at the new equilibrium point, Y increases, interest rate decreases.

b) The government increases taxes.

c) The government increases government spending.

d) MPC increases.

e) the tax rate decreases.

Answer 1

(b) When government increases taxes => disposable income decreases => consumption demand reduces => Y decreases.

On the graph: IS shifts to the left and Y is lower and interest rates also reduce.

(c) When the government increases government spending => demand in the economy increases => demand propagates through the economy with multiplier effect => AD increases => Y increases.

On the graph: IS shifts to the right and at new intersection, Y is higher and interest rates also increase.

(This might subsequently lead to crowding out of private investment if not balanced by an equal increase in liquidity)

d) MPC increases => Multiplier increases => Demand increases/decreases => Y increases/decreases. This increase in Y will be more than normal because multiplier has increased. It must also be noted that in case of withdrawal of demand, the fall be equally amplified.

On the graph: IS curve shifts rightand at new intersection, Y and interest rates are higher. This will be also true vice versa.

(e) Tax rate decreases => Disposable income increases => Consumption/Saving increases => Demand/Investible Surplus increases => Y increases.

On the graph: IS curve shifts right and at new intersection, Y and interest rates also increase.