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?