For each of the following, predict the effects on the equilibrium levels of aggr
ID: 1205923 • Letter: F
Question
For each of the following, predict the effects on the equilibrium levels of aggregate output (Y) and the interest rate (r). Be sure you make predictions for both Y and r!
a. During 2000, the Federal Reserve was tightening monetary policy in an attempt to slow the economy. The Congress passed a substantial cut in the individual income tax at the same time.
b. During the summer of 2003, the Congress passed and President Bush signed the third tax cut in 3 years. Many of the tax cuts took effect immediately. Assume the Fed holds the money supply fixed.
c. In 1993, the Congress and the president raised taxes. At the same time, the Fed was pursuing an expansionary monetary policy.
d. In 2003, the Iraq War led to a sharp drop in consumer confidence and a drop in consumption. Assume the Fed holds the money supply constant.
e. The Fed attempts to increase the money supply to stimulate the economy, but plants are operating at 65 percent of their capacities and businesses are pessimistic about the future.
Explanation / Answer
a. Tightening money policy will shift the LM curve to the left. Cut in the individual income tax will shift the IS curve to the right. So, in both the cases the rate of interest will increase. The effect on aggregate output depends on the magnitude of the shift of the two curves. If both shifts by same amount then equilibrium aggregate output will remain same. If IS shifts by more amount than LM, then it will increase and if LM shifts by more amount then IS, then it will decline.
b. The tax cut will shift the the IS curve to the right. LM curve will remain at the same position. Thus, Rate of interest will increase and aggregate output will also increase.
c. Raising taxes will shift the IS curve towards left and expansionary monetary policy will shift the LM to the right. Thus, the rate of interest will decline. The impact on aggregate output depends on the magnitude of the shift of the IS and LM curve. If it is of equal amount, then aggregate output will remain same. If LM shifts by more amount than IS,then aggregate output will increase and if IS shifts by more amount than LM, then aggregate output will decline.
d, This will leads to decline in Aggregate demand and thus shift the IS curve to the left. Thus, both the rate of interest and aggregate output will decrease.
e. This will lead to decline in the rate of interest but the aggregate output will not increase in this case. This is because even after the decline in rate of interest rate, investment will not be undertaken and thus total aggregate output will not increase much.
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