Question

In: Economics

Assume Australia undertakes a tax reform in response to the debt burden caused by the Covid‐19...

Assume Australia undertakes a tax reform in response to the debt burden caused by the Covid‐19 epidemic. Assume the tax reform includes an increase in GST (goods and services tax) and higher land tax. Illustrate and explain briefly the effect of the tax reform on the IS,LM and LRAS curve of Australia. Discuss the changes in the components of GDP.

Solutions

Expert Solution

Ans. Lets first understand what is IS and LM Curve : Equality of planned expenditures and actual income/output-gives rise to what is called the IS curve. Equilibrium in the money market-is embodied in what is called the LM curve. When we put them together, we get the aggregate demand curve. Because of the ongoing pandemic when Australia is facing high debt and in response to that it decided to increase the GST rates and higher land tax will have impact that output will decline below its long run equilibrium. The marginal propensity to consume (MPC) represents the proportion of an additional disposable income that is consumed or spent. Because the amount that is not spent is saved, the marginal propensity to save (MPS) is MPS = 1 - MPC. According to the consumption function, increase GST taxes will reduce aggregate consumption and IS curve shift to right. The quantity theory of money equation provides a straightforward connection among the nominal money supply (M), the price level (P), and real income/expenditure (Y): MV = PY In this equation, V is the velocity of money, the average rate at which money circulates through the economy to facilitate expenditure. This relationship, which economists refer to as the LM curve, is shown by the upward- sloping curve. Because of the higher debt on account of government borrowing their will also be increase in the interest rates because of the higher government debt. Because of the crowding effect the interest rates will be higher. This can be depicted as follows: Relater IMM/P-(M/P1 LMIM/P> (M/PI Income, Y With lower real money supply, the intersection of the IS and LM curves occurs at a lower level of real income and a higher level of the real interest rate. In terms of GDP, the consumption will be lower , taxes will be higher and decline in total output, income, employment, and sales.


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