In explaining the 2003 bill to cut taxes, President Bush is quoted as saying, “W
ID: 1205335 • Letter: I
Question
In explaining the 2003 bill to cut taxes, President Bush is quoted as saying, “When people have more money, they can spend it on goods and services.”
a. In the IS–LM model, will a tax cut change the money supply in the economy? Explain.
b. In the IS–LM model, does a tax cut shift the IS or the LM curve? Illustrate graphically the impact of the tax reduction on output and interest rates. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values.
c. Based on your answers in a and b, how can you reconcile President Bush’ statement with economics? Can you suggest how his statement could be modified (re-worded?) to be consistent with the IS–LM model?
Explanation / Answer
a.
No. tax cuts don not changes the money supply come from the Federal Reserve.
b.
The IS curve shifts because a change in taxes affects equilibrium in the goods market.
c.
The idea is that lower taxes increases people's disposable income. That rises consumption spending. In the IS-LM model, inferior taxes shifts the IS curve to the right. Output rises and the real interest rate increases. A more correct statement by the President would have been, "When people get to keep more of their disposable income, they can spend it on goods and services."