Question

In response to concerns about a future recession, the government decides to give consumers a tax rebate (this is the same as a tax decrease). Answer the following using the graphical IS-LM model.

a. Draw a graph illustrating the impact of the tax decrease on equilibrium output and the interest rate.

b. Now suppose that the central bank does not believe that a recession is looming and determines that it would like to maintain Y at the pre-rebate level. What type of policy (contractionary or expansionary) must the central bank pursue? Illustrate this policy on your graph from part a.

c. What happens to consumption, saving and investment as a result of the policy mix from parts a and b? Explain briefly.

Answer 1

(a)

Lower tax will increase consumption and output, shifting IS curve rightward, increasing interest rate and increasing output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. Lower tax shifts IS0 rightward to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1.

(b)

Central bank should pursue contractionary monetary policy by decreasing money supply, which will shift LM curve to left, leading to higher interest rate but restoring initial output.

In above graph, LM0 shifts left to LM1, intersecting IS1 at point C with still higher interest rate r2 and restoring output to Y0.

(c)

Since output remains unchanged, consumption and saving both remain unchanged. But increase in interest rate causes investment to decrease.