Question

3. In the IS-LM model, explain how does an increase in taxes affect equilibrium in-come. If you use any diagram, label your axes and curve clearly

Answer 1

An increase in the income tax decreases the disposable income of the people. With the reduced income, people demand less and the output in the economy falls. In the below graph the economy was in equilibrium at point "a" the output in the at that point was at Y and interest rates were at "i".

After an increase in the income tax, the disposable income decreased causing a shift in the Is curve. The new equilibrium is at point "b" but at lower output and lower interest rates.