According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must ______ the money supply.

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BlackTom AI · Accepted Answer

Begin by laying out what the question asks: with Congress raising taxes (a fiscal tightening) and the Fed aiming to hold income (Y) constant, what should the Fed do to the money supply? This situation involves the IS-LM framework, where the IS curve shifts left due to higher taxes, reducing Y and r. The Fed can respond by adjusting the LM curve to offset this effect.
Option 1: increase. This is the correct strategic move. By increasing the money supply, the Fed shifts the LM curve to the right, which lowers interest rates less affected by the tax-induced drop in investment, helping to restore or maintain the original level of income Y despite the fiscal contraction. The intent of expansionary monetary policy here is to counteract the negative demand shock from the tax hike.
Option 2: decrease. Reducing the money supply would shift the LM curve left, raising interest rates and further depressing investment and Y. This would exacerbate the drop in income from the tax increase, making it harder, not easier, to hold Y constant.
Option 3: first increase and then decrease. This adds an unnecessary and confusing sequence. While policy timing can matter, the question asks for a direct action to hold Y fixed in response to a tax rise; a single, immediate increase is the appropriate action to offset the contraction, not an initial rise followed by a reversal.
Option 4: first decrease and then increase. This would momentarily tighten monetary conditions, weakening investment and income, and only later loosen them. That order would not help maintain Y constant in the face of a tax-induced drop; it would likely worsen the stabilization outcome before any offsetting expansion occurs.
In summary, the monetary authority responds to a fiscal contraction by expanding the money supply to shift LM right and stabilize income, making option 1 the appropriate choice. The other options describe policies that would either worsen the outcome or introduce unnecessary timing complications.

BU.220.610.51.FA25 M8 Final Comprehensive Exam - Multiple Choice Questions- Requires Respondus LockDown Browser

According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must ______ the money supply.

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Similar Questions

If, in addition, 𝑅 𝑡 = 𝑟 ¯ , short run output [ Select ] .

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BU.220.610.51.FA25 M8 Final Comprehensive Exam - Multiple Choice Questions- Requires Respondus LockDown Browser

According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must ______ the money supply.

View Explanation

Log in for full answers

Similar Questions

If, in addition, 𝑅 𝑡 = 𝑟 ¯ , short run output [ Select ] .

The IS curve shifts when any of the following economic variables change except:

When the LM curve is drawn, the quantity that is held fixed is:

If the short-run IS-LM equilibrium occurs at a level of income below the natural level of output, then in the long run the price level will __, shifting the ____ curve to the right and returning output to the natural level.

In the IS-LM model, a decrease in government purchases leads to a(n) ______ in planned expenditures, a(n) ______ in total income, a(n) ______ in money demand, and a(n) ______ in the equilibrium interest rate.

An increase in the money supply shifts the __ curve to the right, and the aggregate demand curve ____.

Other things equal, a given change in money supply has a larger effect on demand the:

The tax decrease makes the interest rate ______ and investment ______ in this model.

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

If the short-run IS-LM equilibrium occurs at a level of income below the natural level of output, then in the long run the price level will , shifting the __ curve to the right and returning output to the natural level.

In the IS-LM model, a decrease in government purchases leads to a(n) in planned expenditures, a(n) in total income, a(n) in money demand, and a(n) in the equilibrium interest rate.

An increase in the money supply shifts the curve to the right, and the aggregate demand curve __.

The tax decrease makes the interest rate and investment in this model.