Problem
Use the IS-LM graph to answer the following questions. Suppose the economy is initially at the equilibrium. Now assume that taxes are reduced.
a) What effect will this cut in T have on the IS curve?
b) Given the tax policy above, now suppose the Bank of Canada wants to maintain Y at the initial level. What type of policy must the Bank pursue (i.e., contractionary or expansionary) to maintain output at its initial level? What effect will this policy have on the LM curve? Illustrate the effects of the lower T and the Bank response on the IS and LM curves. In your graph, clearly label the new equilibrium.
c) What happens to consumption, saving and investment as a result of this policy mix? Briefly explain.