Question

Use the IS-LM graph provided below to answer the following questions. Suppose the economy is initially at point A in the graph. Assume that taxes are reduced.

a.     What effect will this cut in T have on the IS curve?

b.    Given the tax policy above, now suppose the Bank of Canada wants to maintain Y at the initial level. What type of policy must the Bank pursue (i.e., contractionary or expansionary) to maintain output at its initial level? What effect will this policy have on the LM curve? Illustrate the effects of the lower T and the Bank response on the IS and LM curves. In your graph, clearly label the new equilibrium.

c.     What happens to consumption, saving and investment as a result of this policy mix? Briefly explain.

Answer 1

a) Due to the reduction in tax, people will get a rise in their disposable income which will directly raise the level of consumption in the economy.

GDP = C + I + G + X -M

As C (Consumption) and GDP have positive relationship with each other, rise in C will raise the GDP which will shift the IS curve to its right from IS to IS1 raising rate of interest from i to i1 and output level from Y to Y1.

b) If Government of Canada wants to maintain the same level of output, they will adopt a contractionary monetary policy which will shift the LM curve to its left which will shift the economy from B to C causing interest raise to rise further to i2 level and output level to shift back to its initial level.

c) As rate of interest have investment level holds a negative relationship with each other, a rise in rate of interest will lower the investment level in the economy. Savings will rise due to the rise in interest rate. Consumption will fall as Consumption + Saving = Income. When savings rises, consumption have to fall.