Question

Given a proportional tax system (with tax rate t and T=tY), use an IS-LM diagram (with upward sloping LM function) to explain the impacts of an increase in propensity of consumption (c1) on equilibrium output, interest rate and private investment? Use an IS-LM diagram and some sentences to explain your answer.

Answer 1

LM Curve :-  The LM Curve is the liquidity preferance and money supply curve , and it shows the relationship between real output and intrest rates. When income increases and money demand increases and bond demand decreases for a given interest rate.

IS Curve:- The set of all levels of intrest rates and output at which total investments equal to total savings. At lower interest rates , investment is higher , which translates into more total output (gdp), so the IS curve slopes downward and to the right.

IS-LM Curve :-  The intuition behind the positive slop of LM is a follows : An increase in the interest rate reduces the demand for money and an increase in income increases it. to keep the demand for money equal to a constant money supply as the interast rate rises and we move along the LM Crurve, the level of income must increase. An increase in the money suppy holding the real intreast rate constant requires a higher level income to make the demand for money equals the supply , shiffting LM to the right. Overall equilibrium will uccur where the IS-LM curves cross. IN an economy  that is closed to international trade , an increases in the money supply in the figure will shift LM to the right causing the intreast rate to fall as the public ties to reestablish portfollio equilibrium by purchasing assets.