Consider a variant of the IS-LM model studied in class, where Investment, I = I0 + b1*Y - b2*r, and the demand for money, L(r, Y) = m0 + k*Y - h*r. We know with certainty that a tax increase must cause which of the following? a. a decrease in the interest rate and an ambiguous effect on investment.
b. an increase in the interest rate and an upward shift in the LM curve.
c. no change in output if the Fed simultaneously pursues expansionary monetary policy.
d. a decrease in the interest rate and an increase in investment.

The correct answer is D

Explanation:

Taxes have a regressive effect on Aggregate Consumption which in turn catalyses a decrease in output/income.

Lower income/output will lead to lower interest rate because a drop in demand will result in a drop in supply. When companies are not producing, there is no point seeking investment in the form of debt or equity. Hence interest rate also drops.

At this point, businesses become interested in borrowing funds given the low rate of interest.

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