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According to our three-equation model, how would an increase in direct taxes affect inflation in the...

  1. According to our three-equation model, how would an increase in direct taxes affect inflation in the short-run? In the medium-run?
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Answer #1

As per 3 equation model, Infkation takes atleast 2 years as time lag to relaise the effect of certain economic activity. when direct tades are raised the overall prices of goods and services are raised as organisations now pay more corporate taxes which pushes prices of goods higher and inflation soars in long run but in short run there is no immediate impact due to policy lag.

And hence as Per 3 equation model we see following effect.

  1. Phillips curve- As inflation rises unemployment decreases.
  2. Investment savings - IS curve shifts leftwards as higher income taxes cause lower savings and lower investment due to lower disposable incomes
  3. Monetary policy reaction - Since inflation soars, the interest rates are riased as contractionary monetary policy
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