Question

Suppose the US government decides to decrease taxes, as it did on 22 December, 2017, use the IS-LM model to discuss how the Fed can stabilize national income at a new equilibrium interest rate

(b) Did the tax policy produce its intended impact on the IS curve? Why?

Answer 1

(a) A decrease in tax will increase disposable income (if personal tax is reduced) and/or increase business investment (if corporate tax is reduced). Both cases will increase output, shifting IS curve rightward and increasing both interest rate and output. If Fed wants to keep national income (output) stable, it should decrease money supply, which will shift LM curve leftward, increasing interest rate and decreasing output until new equilibrium is restored at a further higher interest rate but at same output level.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. As IS shifts right to IS1, it intersects LM0 at point B with higher interest rate r1 and higher output Y1. To keep output stable, Fed keeps decreasing money supply leading to leftward shift in LM0 until the new LM curve is at LM1, intersecting IS1 at point C with further higher interest rate r2 and output being restored at Y0.

(b) A decrease in tax will increase disposable income (if personal tax is reduced) and/or increase business investment (if corporate tax is reduced). Both cases will increase output. At the same time, lower tax will increase budget deficit, which increases government borrowing for deficit financing purposes. Higher borrowing will increase interest rate, thus decreasing investment demand. A fall in investment will decrease output. As a net effect, increase in output will not be as high as intended, due to this crowding-out effect where lower investment decreases some of the output that increased from a cut in tax. Therefore effect of this fiscal policy will not have full impact on output due to crowding-out effect.