Question

Use the IS-LM model to answer this question and assume that the Bank of England (Central Bank in the UK) controls the interest rate. Suppose that there is a simultaneous decrease in tax due to current energy crisis and increase in interest rate to support the economy suffering from high inflation.

Explain what effect this particular policy mix will have on output (or income) and the money supply in the UK economy.

Answer 1

In the IS-LM model, a decrease in tax and an increase in interest rate will lead to an increase in output and a decrease in the money supply in the UK economy.

Step-by-step explanation:

In the IS-LM model, the IS curve represents the relationship between output (Y) and the interest rate (r), while the LM curve represents the relationship between output (Y) and the money supply (M). By assuming that the Bank of England controls the interest rate, a decrease in tax due to the current energy crisis and an increase in the interest rate to support the economy suffering from high inflation will have the following effects:

1. The decrease in tax will shift the IS curve to the right, increasing the level of output (Y).
2. The increase in interest rate will shift the LM curve to the left, reducing the money supply (M).

Therefore, the policy mix will lead to an increase in output (or income) and a decrease in the money supply in the UK economy.