Question

Use the IS-LM-PC model to explain how the economy adjusts to an increase in taxes in the medium run. Assume that the economy starts at a medium run equilibrium No graph necessary. Be sure to specify which curve shifts in the medium run. State how output, inflation, and the real interest rate change relative to the initial point where the economy started. Make sure that you state how inflation evolves differently under anchored expectations and under backward-looking expectations.

Answer 1

An increase in taxes leads to a leftward shift in the IS curve, thus causing the equilibrium interest rate and output to falland this would lead the LM curve to shift downward due to the neutrality of money concept, till Y=Yn but at a lower interest rate. Thus the investment increases and composition of AD changes. This causes the AD curve to also shift to the leftcausing price to fall which leads to inflation being lower than expected. Thus, price expectations are adjusted downwards and AS shifts till the equilibrium is reached where Y=Yn but at the lower price level. At the lower price level. in the medium run P=Pe. So, during anchored expectations , the mean inflation rate at the end becomes somewhere around the target inflation rate and in the backward looking expectations, considering it is medium run, people more or less correctly adapt to the expectations  at the lower inflation rate.