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In: Economics

Using the IS-LM model, show and explain how a decrease in taxes affects the interest rate...

Using the IS-LM model, show and explain how a decrease in taxes affects the interest rate and output.

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Expert Solution

It shall be noted that when the taxes decrease (deltaT < 0), then tax multiplier tells that the IS curve would shift to the right by an amount equal to (-MPC/(1-MPC))*(deltaT) from IS2 to IS1

The income and the interest rate both increase from Y2 to Y1 and r2 to r1 respectively.

Disposable income increases from Y2 to Y1 because income is higher and the taxes are lower. This causes consumption to increase.

With the fall in the tax rate, the LM curve remains unchanged. The economy moves along the LM curve.

As disposable income increases, it increases the demand for money. Given that the supply of money is fixed, the interest rate must increase to pull down the demand for money and maintain equilibrium.

The rise in the interest rate causes investment to fall.

Thus, as the tax decrease, the income and the interest rate both increase.

Rahul Sunny answered 2 years ago
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