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Running head: ECONOMICS 3301.1
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ECONOMICS
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Question 1 (8 points)
A. Suppose there is an increase in taxes. In the IS-LM model, which curve will be
affected and how? How will this affect output and the interest rate? Explain with
the help of a graph. (3 points)
When the taxes increase the IS curve is affected in the IS-LM model. WhenC(consumption),
I(interest), G(government spending) the IS curve shifts right (left). When T(taxes) increases, all
else constant, the IS curve shifts left because taxes effectively decrease consumption. Increase in
the taxes will lead to decrease in output which will result in decrease in the interest rates
(Dwivedi, 2010). That is because it works by shifting the IS curve upward rather than shifting the
LM curve. Of course, if T increases, the IS curve will shift left, decreasing interest rates but also
aggregate output.
B. Suppose the central bank is committed to maintaining a fixed interest rate monetary
policy. What type of monetary action would it take to prevent the interest rate from
changing in (A)? How would output change as a result?
(2 points)
ECONOMICS
The Contractionary monetary policy can be used in the question A.This means the output will
remain constant since the interest rate remains constant.
B. How would consumption, total saving and investment change in A. and in B?
Explain fully. (3 points)
Increase tax rates decreases in current income decreases the level of consumption and total
saving. This because the level of income decreases for the consumer and vice versa.
Additionally, the investment change will reduce because the marginal propensity to ...