Increases in the budget deficit are believed to cause reductions in investment (crowding out). Based on your understanding of the IS-LM model, will a tax cut cause a reduction in investment? Explain using a graph.

Question

Explain in detail what short run effect(s) a Fed sale of bonds will have on:
(a) The money market diagram; (b) The LM curve; and (c) the IS curve.

Answer 1

According to the IS-LM model, a tax cut can cause an increase in investment in the short run. This is because a tax cut increases disposable income, which leads to an increase in consumption and aggregate demand. As a result, firms may increase their investment to meet the higher demand.

The graph below illustrates this concept:

The original IS-LM model is shown in blue lines. A tax cut shifts the IS curve to the right, from IS to IS'. This is because the tax cut increases disposable income, which increases consumption and therefore aggregate demand. As a result, the equilibrium output level increases from Y to Y'.

However, the increased demand may also lead to an increase in interest rates as investors try to take advantage of the higher demand for loans. This is represented by a shift in the LM curve to LM', which represents a higher interest rate for a given level of output. The intersection of IS' and LM' occurs at point E', which indicates that the economy is at a higher equilibrium output level.

(a) A Fed sale of bonds will decrease the money supply in the economy. This will cause an increase in the interest rate, as borrowers compete for a smaller pool of funds. This is shown in the graph below:

The original equilibrium point in the money market diagram is shown by the intersection of the LM and MD curves at point A. A Fed sale of bonds shifts the MD curve to the left, from MD to MD', which represents a decrease in the money supply. As a result, the equilibrium interest rate level increases from i to i'.

(b) The increase in the interest rate caused by the Fed sale of bonds will also cause a shift in the LM curve. This is because the LM curve represents the combinations of interest rates and output levels that allow for equilibrium in the money market. This is shown below:

The original LM curve is shown in blue, intersecting the IS curve at point A. A Fed sale of bonds causes the interest rate to increase, which shifts the LM curve to LM', represented by the red lines. This shift indicates that, for a given level of output, the interest rate must be higher to maintain equilibrium in the money market.

(c) The shift in the LM curve caused by the Fed sale of bonds will also affect the IS curve. This is because the IS curve represents the combinations of interest rates and output levels that allow for equilibrium in the goods market. This is shown below:

The original IS curve is shown in blue, intersecting the LM curve at point A. The increase in interest rates caused by the Fed sale of bonds will decrease investment and consumption, which will shift the IS curve to IS', represented by the red lines. This shift indicates that, for a given interest rate level, the output level must be lower to maintain equilibrium in the goods market.

Overall, a Fed sale of bonds will cause an increase in interest rates, which will reduce investment and decrease the equilibrium output level. However, the specific effects on the economy will depend on various factors, such as the initial state of the economy and the magnitude of the Fed's actions.