Question

3. a) In the budget of fiscal year 2020-21, finance minister proposes to increase the tax-free income limit for individual taxpayers to Tk 3 lakh from Tk 2.5 lakh. What will be its effects on interest rate and income level of Bangladesh economy? Explain with the help of IS-LM model.
b) Check the effectiveness of fiscal or monetary policy under Classical supply assumption.

Answer 1

3. a) Increasing the tax-free income limit for individual taxpayers is a kind of expansionary fiscal policy. This strategy aims at putting more disposable income in the hands of the consumers. Now taxpayers with income of up to Tk 3 lakh will be exempt from any taxes thus increasing the pool of consumers who do not have to pay taxes. This ideally should have the impact on increasing consumption in the economy.

In the IS-LM model, the IS curve will shift to the right. The equilibrium income and interest rate, which were previously at Y,I now increase to Y',I'. The purpose of the expansionary fiscal policy followed by the government is to increase the level of income in the economy.

b) Classical supply consumption states that market self-regulates. Prices are flexible in the economy and the supply creates its own demand. It also states that there is equality between savings and investments. With these assumptions, any action undertaken by the government would lead to ripple effects that could set in motion market's self-regulating forces.

For instance, in the answer above, when the interest rates increase, it will lead to less loanable funds available in the credit market, unless the government controls the interest rates too. This would shift the LM curve to the left, and at this level of interest rates, the income in the economy might eventually fall to Y".