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Use the IS-LM-PC model to illustrate how the economy adjusts to an increase in taxes both...

Use the IS-LM-PC model to illustrate how the economy adjusts to an increase in taxes both in the short run and in the medium run.

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In the IS Lm model, and increase in taxes will mean that the disposable income for consumers will fall and so this will cause a fall in consumption. Also a tax increase will cause a fall in investment as firms find it tougher to invest. The fall in consumption and investment will cause the IS curve to shift leftwards and this causes a fall in interest rates and the output level. Correspondingly, the aggregate demand curve will shift leftwards and will cause a fall in the prices and the quantity in the short run. Over time the economy adjusts itself back to the old output level but at a higher price level. The economy finally settles at A.

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