1. Assume that the economy is at full employment. The government decides to cut taxes to give the economy an extra boost.
a. Using the IS-LM model, show the short run effect of this tax cut What will happen to output and the interest rate? (use graph) Note: this is NOT the only model to analyze the short-run impact of tax cut on GDP. The IS-LM model is a Keynesian model which focuses on the demand side of the economy. Alternatively, the supply side emphasizes the positive impact of a tax-cut on the economy as it can encourage more investments and thus increase employment and output.
b. What will happen in the long run?
c. If the Federal Reserve is following a policy of price stability, how should they react to the tax increase? If the Fed action is implemented, will the tax cut succeed in boosting output? Use a fully-labeled diagram and two or three brief sentences to explain your answers.