Chapter 30: Problem 48

If the government gives a $\$ 300$ tax cut to everyone in the country, explain the mechanism by which this will cause interest rates to rise.

Short Answer

Expert verified

A $300 tax cut for everyone in the country increases disposable income, resulting in higher consumer spending and aggregate demand. This increased demand for goods and services also increases the demand for money, causing interest rates to rise.

Step by step solution

Understand the effect of tax cuts on disposable income

A tax cut increases the disposable income of individuals, as they now have more money at their disposal after paying their taxes. In this case, a `$300` tax cut per person will lead to increased disposable income by the same amount.

Relate disposable income to consumer spending

When individuals have more disposable income, they are more likely to spend that extra money on goods and services. Consumer spending is an essential component of aggregate demand, which is the overall demand for goods and services within a country.

Analyze the impact on aggregate demand

Increased consumer spending due to a tax cut results in higher aggregate demand in the economy. When aggregate demand grows, economic activity expands, leading to an increased demand for resources (labor, capital) to produce more goods and services.

Consider the effect on the money market

The expansion in economic activity due to higher aggregate demand leads to increased demand for money in the economy. As businesses and consumers demand more money to buy goods and services or make investments, the demand for money increases in the money market.

Determine the impact on interest rates

The higher demand for money leads to an increase in interest rates. This occurs because the supply of money is limited, and when demand outpaces supply, the price (interest rate) of borrowing money will rise. In conclusion, a `$300` tax cut for everyone in the country leads to increased disposable income, resulting in higher consumer spending and aggregate demand. This increased demand for goods and services also increases the demand for money, causing interest rates to rise.