TUT 3 SOLUTIONS

1. Please refer to the relevant text in Froyen on page 64 of Chapter 4, the PDF document
(The Supply-side effects of income tax cut. You are required to draw all the graphs and
explain them in detail).

2. (a) Graphically show and analyze the effects of an increase in taxes in the IS-LM
model.

Figure 7-6

An increase in taxes shifts the IS schedule to the

left from IS0 to IS1. Income falls as taxes rise
because the tax increase lowers disposable income
(Y - T) and causes consumption to decline. As
income declines because of the tax increase,
money demand declines and bond demand
increases, and this causes the interest rate to fall.

(b) Utilize the IS-LM model and analyze the effects of a decrease in the quantity of
money.

Figure 7-7

Assume that the IS and LM schedules are IS 0 and

LM0, and income is at Y0 and interest is at r0. A
decrease in the money stock from M0 to M2 would
shift the LM curve up from LM0 to LM2. The
equilibrium level of income falls from Y0 to Y2
and the interest rate rises from r0 to r2.

8. (a) Why do the Keynesians prefer a policy mix of "tight" fiscal policy and "easy"
monetary policy?
Explain this preference with an aid of a diagram: Make use of the slides on Policy mix
available to illustrate this relationship. However the explanation should show that:

An expansionary monetary policy increases investment. With an expansionary fiscal

policy investment declines. Therefore, the Keynesians prefer an expansionary monetary
policy since investment is important for the long-run growth of the economy.
 Multiple Questions

1. C 2. C 3. 4.B 5. A 6.A 7.B 8.C 9.A 10.B 11.A