Practice question

Taxmania is a closed economy with government. Aggregate demand is described by 1' = C + J' + G, where c denotes aggregate consumption, I denotes investment and 6 denotes government expenditure. Disposable income is denoted by YD; income in Taxmania is taxed at a rate t, while the government can also deduct taxes as a lump sum '1". In particular: r: = 40 + 0.811, YD = (1 t)? T r = 200 61' G = 360 t = 0.25 T = o (a) Explain briey what the IS curve represents and nd its equation for Taxmania. [6 marks] (b) Find the multiplier for Taxmania and explain its meaning. What does it depend on? [4 marks] (c) The central bank of Taxmania targets the real interest rate and has set r = 4. Use the IS-LM framework to nd the level of output in the economy. Show that Taxmania has a balanced budget. [6 marks] (d) Due to the coronavirus pandemic the government of Taxmania increases expenditure on healthcare and vaccinations, raising government spending to G = 560. What is the effect of this on aggregate spending in the economy? Show that Taxmania is now running a budget decit. [6 marks] (e) Concerned about debt, the government of Taxmania decides to raise taxes. This can be done by either (i) raising the income tax rate r or (ii) introducing a lump sum tax 1". Under which tax system will scal policy through 6 be more eective? [8 marks]