Question

Suppose that the government decides to impose an income tax as opposed to a “lump sum” tax. We can now model the economy as follows.
C=100+.75YD    I=200  
G=300      
Where Yd = Y - T = Y - .2Y and .2 represents a 20% income tax.

1. Solve for equilibrium income in this case. Graph this economy and the economy we modeled in question 2 on the same graph. Why do they differ?
2. What is the size of the government’s surplus or deficit in this case?
3. What is the fiscal multiplier in this case? Why is it different than in question 2?
4. Graph the money supply and explain how the central bank can increase the money supply. Show this increase on your graph.

Answer 1