According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must ______ the money supply.

Question

BlackTom AI · Accepted Answer

Begin by laying out what the question asks: with Congress raising taxes (a fiscal tightening) and the Fed aiming to hold income (Y) constant, what should the Fed do to the money supply? This situation involves the IS-LM framework, where the IS curve shifts left due to higher taxes, reducing Y and r. The Fed can respond by adjusting the LM curve to offset this effect.
Option 1: increase. This is the correct strategic move. By increasing the money supply, the Fed shifts the LM curve to the right, which lowers interest rates less affected by the tax-induced drop in investment, helping to restore or maintain the original level of income Y despite the fiscal contraction. The intent of expansionary monetary policy here is to counteract the negative demand shock from the tax hike.
Option 2: decrease. Reducing the money supply would shift the LM curve left, raising interest rates and further depressing investment and Y. This would exacerbate the drop in income from the tax increase, making it harder, not easier, to hold Y constant.
Option 3: first increase and then decrease. This adds an unnecessary and confusing sequence. While policy timing can matter, the question asks for a direct action to hold Y fixed in response to a tax rise; a single, immediate increase is the appropriate action to offset the contraction, not an initial rise followed by a reversal.
Option 4: first decrease and then increase. This would momentarily tighten monetary conditions, weakening investment and income, and only later loosen them. That order would not help maintain Y constant in the face of a tax-induced drop; it would likely worsen the stabilization outcome before any offsetting expansion occurs.
In summary, the monetary authority responds to a fiscal contraction by expanding the money supply to shift LM right and stabilize income, making option 1 the appropriate choice. The other options describe policies that would either worsen the outcome or introduce unnecessary timing complications.

According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income constant, then the Fed must ______ the money supply.单项选择题

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