Homework#2

1. a) Calculate and sign the tax multiplier (dY/dt) in the following model.

Y = C[(1-t)Y] + I[ i ] + G

M = L[i, Y]

Answer:

Consider, I(i) = -b.i

Md = k . y – l . i , Ms = M-- / P

At equilibrium,

Md = Ms

⇨ k . y – l . i = M/ P
⇨ i = - (M / P. l) + (k / l) . y ------- (1) [Equation of LM curve)

Now, Y = C + I + G

Y = C (1 – t).Y – b.i + G

Y = C.Y – C.t.Y – b. {- (M / P. l) + (k / l) . y} + G

Y = C.Y – C.t.Y + (b.M / p.l) – b. (k / l). Y + G

dY = C.dY – C ( t.dY + Y. dt) – b. (k / l). dY

dY = C.dY – C.t.dY – C. Y. dt – b. (k / l). dY

{ 1 – C – C.t + b. (k / l) } dY = - C. Y. dt

{ 1 – C (1 – t) + b. (k / l)} dY = - C. Y. dt

dY / dt = - C. Y / { 1 – C (1 – t) + b. (k / l)} < 0

Thus, tax multiplier is given by

dY / dt = - C.Y /{1 - C (1-t) + b.(k/l) } < 0

b) Draw an IS-LM diagram and illustrate an initial position. Show the new equilibrium after
the increase in ‘t’.

Change in the tax rate effects the slope of the IS curve and the IS curve becomes steeper. The
IS Curve does not shift because there is no change in autonomous part. The Equilibrium
moves from point A to point B. The interest rate falls from i1 to i2 and the income level falls
from Y1 to Y2 .

2. a) Calculate and sign the tax multiplier (dY/dt) in the following model.
Y = C[(1-t)Y] + I[ i ] + G
M = L[i, (1-t)Y]

Answer:

Given,

Y = C[(1-t)Y] + I[ i ] + G
M = L[i, (1-t)Y]

dy = C′ [dy – tdy – ydt] + I′ (di) + di -------(1)

dm = L′ di + L′ dy - L′ [ ydt – tdy] -------(2)

Substituting di from (2) and putting it in (1) equation we get,

(dm - L′ dy + L′ ydt – L′ tdy) / L′ = di

(Dm / L′ ) – {L′ dy (1+t) / L′} + (L′ ydt / L′) = di

(Dm / L′) - dy(1+t) + ydt = di

dy = C′ [dy – tdy – ydt] + I′ {(Dm / L′) - dy(1+t) + ydt} + {(Dm / L′) - dy(1+t) + ydt}

dy/dt = - C′y / {1 - C′(1-t) + i′ (k′/l′)} where, k′ = ydt -tdy

When tax increases, policy induced, and consumption changes is negative. So, tax multiplier
is negative.

b) Draw an IS-LM diagram and illustrate an initial position. Show the new equilibrium after
the increase in ‘t’ assuming that dY/dt = 0.

Answer:

c) Explain why an increase in ‘t’ shifts the LM curve down and to the right.

Answer: Suppose tax increases, disposable income (y-t) decreases. Hence income decreases.
When income decreases, interest rate (r) decreases. So, increase in “t” will shift the LM curve
down to the right.