Question

By relying on the IS LM Model explain what will be the effect of a tax cut policy on the equilibrium level of income. Explain in detail the different steps, how does this policy impact the investment?

Answer 1

Solution:

Initially the equilibrium is at point E. Where IS and LM both intersect each other.At this level of interest rate i' the equilibrium output is Y*. Now suppose the tax rate is reduced. This will shift the IS curve rightward and a new equilibrium will be established at point E' at the same level of interest i.e i'. This shift in the IS curve will :

Increase the income level from Y* to Y''.As the income level in the economy increases demand for money will also increase,this will cause the interest rate to increase.This increase in interest rate will reduce the level of investment in the economy.This is because interest and investment have negative relationship.

So slowly and slowly the interest rate increases in the economy and the investment level decreases. This is also known as crowding out where the level of private investment in the economy lowers down.This will make us move from point E'' to E' and the interest rate will reach to i Where the equilibrium level of income is Y'