Question

Answer the following question:

(a) Using the Keynesian Cross, explain how a tax cut, ∆T, affects nation income. Using the appropriate multiplier, what is the magnitude of the change in national income, ∆Y . What is the change in consumption and the change in investment? Explain. (Hint: for investment, what are we treating as exogenous in this model?)

(b) Use the IS-LM model to analyze the effect of the policy in part (a). How does the change in national income compare to what you found in part (a)? What accounts for the difference? How does the change in consumption compare to what you found in part (a)?

Please show all graphs. I have done question A but am Stuck on question B

Answer 1

(Part B)

When a tax cut is implemented, disposable income increases, thus increasing consumption. IS curve shifts rightward, increasing both interest rate and 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. When IS0 shifts right to IS1, it intersects LM0 at point B with higher interest rate r1 and higher output Y1.

In Keynesian cross, when tax falls,

Increase in output (Y) = Decrease in tax x Tax multiplier

But in IS LM model, higher interest rate crowds out private investment, so increase in Y is less than the increase in Y in Keynesian cross,

For the same reason, increase in consumption in IS-LM model is less than the increase in consumption in Keynesian cross,