Question

Suppose that money demand depends not on just income – Y – but on disposable income,

denoted as Y-T (and so income minus taxes). For example, the LM equation would become:

M/P = 100 + (1/4)*(Y-T) – 10r

The IS equation is the same as usual.

a) If there is a change in taxes, which curve or curves will now shift?

b) What happens now to output and interest rates when the government lowers taxes

Answer 1

Note: The exact changes can not be stated without the equaiton of the IS curve.

Given, the LM curve is or where M will be money supply. The IS equation will be somewhat (for X be any positive constant).

(a) If there is a change in taxes T, both curves will shift as both are determined by T now. For a change in increase in tax, the LM curve would shift by 0.25 amount , to the right, and the IS curve would shift by amount, to the right. Both curves would shift right with increase in tax meaning that for each interest rate, the output will be more than before due to the tax-cut. Vice-versa is true for decrease in tax.

(b) If government lowers taxes T, as established in part (a), the IS and LM curve both would shift to right, and output will definitely be increased. However, the effect on the interest rate will be ambigious, as it may increase, decrease, or won't change at all, depending on how much the IS and LM curve shifts. To be more precise, if IS shifts more than LM, the interest rate would increase; IS shifts less than LM, the interest rate would decrease; and if IS shifts exactly as LM, interest rate won't be changed at all.