Chapter 17: 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

The $\$ 300$ tax cut given to everyone leads to an increase in disposable income, resulting in higher aggregate demand as consumers spend a portion of the extra money. This increase in demand and economic activities subsequently raises the demand for money. If the central bank does not adjust the money supply to match the increased demand for money, the interest rates will rise due to the forces of supply and demand, promoting saving and discouraging excessive borrowing to maintain financial stability.

Step by step solution

Introduction of the tax cut

A tax cut of $\$ 300$ is given to everyone in the country. This means that individuals now have an additional $\$ 300$ in their disposable income, which they can spend, save, or invest. The tax cut is aimed at boosting the economy by increasing consumers' purchasing power and stimulating demand.

Increase in aggregate demand

With the tax cut, consumers are likely to spend a portion of the extra income and save or invest the rest. This increase in spending results in a higher aggregate demand, which reflects the total demand for final goods and services in the economy. Higher aggregate demand would lead to higher production and, subsequently, higher output and employment.

Increase in demand for money

As the economy expands due to the increase in spending and production, there is a higher demand for money. This higher demand for money is mainly influenced by business transactions associated with the rise in aggregate demand, as well as a higher velocity of money.

Central bank's intervention

The central bank is responsible for managing monetary policy and maintaining price stability. To accommodate the increased demand for money, the central bank may choose to increase the money supply by purchasing government securities or lowering the reserve requirement for banks. However, if the central bank does not increase the money supply to match the increase in demand for money, the interest rate will rise.

Rise in interest rates

If the central bank does not sufficiently increase the money supply to meet the increased demand for money, the forces of supply and demand will push the interest rates upward. As borrowers compete for the limited availability of funds, lenders can charge higher interest rates for loans. This rise in interest rate would encourage saving and discourage excessive borrowing, ultimately helping to maintain financial stability in the economy. In conclusion, the $\$ 300$ tax cut given to everyone in the country would lead to an increase in aggregate demand, a higher demand for money, and eventually, a rise in interest rates if the central bank does not adjust the money supply in response to the increased demand.