Now that you understand how the IS curve and the LM curve are derived and what makes them shift, let’s start using them to make some economic predictions. Suppose you are responsible for forecasting interest rates and output in the future. One night you hear the President say, “To balance the Federal budget (spending – tax revenue) taxes must be increased.”

  1. Is the IS curve or the LM curve affected by taxes ?
  2. How do you think an increase in taxes will affect the IS curve ?
  3. How are output and interest rates affected by increased taxes, graphically represented by the leftward shift of the IS curve ?
  4. Click on the Reset button and then reduce taxes in the economy. You do that by shifting the IS curve rightward. How does a tax reduction affect output and the interest rate ?