Question

Draw the graphs by hand. There are directions for submitting the assignment on Canvas

In the early 1980s, the U.S. government cut taxes and ran a budget deficit, while the Fed decreased the money supply. Show the effects of these policies together on an IS‐LM diagram. Use a Keynesian analysis. Identify the short‐run equilibrium. What happens to output and the interest rate in the short run?

Answer 1

A tax cut increases disposable income, which increases consumption and saving, which shifts IS curve to right, increasing interest rate and increasing output. At the same time, decrease in money supply shift LM curve to left, increasing interest rate and decreasing output. The net effect is a definite increase in interest rate, but effect on output is indeterminate unless we know exact magnitude of shifts in IS and LM curves.

In following graph, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial interest rate r0 and output Y0. When money supply decreases, LM0 shifts left to LM1, and the tax cut shifts IS0 rightward to IS1, intersecting LM1 at point B with higher interest rate r2 and new output Y1.