Essay 4 (Question only) - Essay Question 4(Lecture 4 Discuss the mechanism through which the following event translate into demand shocks a An increase

Essay 4 (Question only) - Essay Question 4(Lecture 4...

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Essay Question 4 (Lecture 4) Discuss the mechanism through which the following event translate into demand shocks: a) An increase in income taxes The effect of an increase in income taxes can be clearly observed through the IS-LM model. An increase in income taxes will clearly affect expenditure through consumption. Tax increases make consumers spend less and thus decreases planned expenditure. Tax multiplier in Keynesian cross tells us that this change in policy decreases level of income at any given interest rate. Furthermore, the IS curve will shift inwards by the amount of the tax multiplier. Increase in income tax will reduce income and thus consumption, and also interest rates. Therefore, there will lower aggregate demand. How economy will respond to tax increase depends on how central bank responds. CB may hold money supply constant, hold interest rate constant or hold level of income constant by raising money supply.

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