Use the IS-LM model to graphically illustrate the initial effect of each of the following on the equilibrium levels of output and the real interest rate. a. A reduction in the tax rate on capital increases desired investment by firms. b. An influx of working-age immigrants increases labor supply and lowers wages firms have to pay their workforce. c. Increased usage of mobile payment services such as Venmo has reduced the demand for money.

A. reduction in the effective tax rate on capital will increase the desired investment relative to the desired savings level which will increase the interest rate in the market. Hence, IS curve will shift up to the right. This is shown in the figure in attached file

When the curve shifts up to the right, the real interest and the output level increase as a result.

Output increases because of a higher investment level in the economy and real interest rate increases because of a higher money demand due to a higher output (income). This is the short-run effect of a reduction in the efecctive tax rate on capital. The short-run equilibrium is at ‘E2’.

In the long-run, a higher output will increase the employment level in the economy which will increase the cost of production for the firms. As a result, the price level rises and the LM curve shifts up to the left. The final equilibrium is at ‘E3’, where the interest rates are even higher and the output level is back to the original level.

B. An increase in the expected inflation rate (πe) will decrease the demand for money and the money demand curve will shift downwards to the left. As a result, the real interest rate level in the market will decrease. Hence, the LM curve will shift down to the right.

The real interest rate will decrease and the output level will increase. The equilibrium in the short-run is attained at ‘E2’.

Eventually, the price level also increases due to an increase in the expected inflation rate and the LM curve shifts (up to the left) back to its original position and the original equilibrium level will be restored.

C. An equilibrium in the labor market leads to a full-employment level (N*) and the full employment level (Y*).

An increase in the labor supply will decrease the real wage rate in the market and increase employment.

A rise in the employment causes the output to increase and there will be a shift in the full employment line/curve to the right.

To restore the equilibrium, the price level declines which will shift the LM curve down to the right. Since output has increased and the real interest rate declined, consumption and investment will get a boost and both variables will increase.

Therefore, the real wage rate, real interest rate, and the price level decline; and employment, output, consumption, and investment will increase.

Explanation:

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