Question

Consider the market for money illustrated in the figure below. Assume the market initially (just prior to the legislation) is in equilibrium at point A. What effect will the tax cuts have on the market for money?

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Answer 1

Due to the tax cut the aggregate demand curve will shift upward to the right. This is because, for a given level of money supply a decrease in the taxes will raise the level of disposable income in the economy. With the increase in the level of income, the transaction demand for money will rise. As a result, for a given level of money supply, people will start to withdraw money from their speculative balances. This will put pressure in the money market, and as a result the price of bonds will decline while the interest rate (yield) will rise to keep the money market in equilibrium. This will reduce investment demand in the economy.

So, the final result of tax cut will be increased consumption expenditure, rise in the interest rate and decline in the investment demand.