Taxmania is a closed economy with government. Aggregate demand is described by Y=C+I+G, where C denotes aggregate consumption, I denotes investment and G denotes government expenditure. Disposable income is denoted by Y_D; income in Taxmania is taxed at a rate t, while the government can also deduct taxes as a lump sum T.

In particular:

C=40+0.8Y_D

Y_D=(1-t)Y-T

I=200-6r

G=360

t=0.25

T=0

(a) Explain briefly what the IS curve represents and find its equation for Taxmania.

(b) Find the multiplier for Taxmania and explain its meaning. What does it depend on?

(c) The central bank of Taxmania targets the real interest rate and has set r=4. Use the IS-LM framework to find the level of output in the economy. Show that Taxmania has a balanced budget.

(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 deficit.

(e) Concerned about debt, the government of Taxmania decides to raise taxes. This can be done by either (i) raising the income tax rate t or (ii) introducing a lump sum tax T. Under which tax system will fiscal policy through G be more effective?