A tax cut combined with tight money, as was the case in the United States in the early 1980s, should lead to a:
A) rise in the real interest rate and a fall in investment.
B) fall in the real interest rate and a rise in investment.
C) rise in both the real interest rate and investment.
D) fall in both the real interest rate and investment.

Question

Quizplus · Accepted Answer

A tax cut would increase disposable income and potentially increase aggregate demand, leading to upward pressure on the price level. In order to combat this inflationary pressure, the Fed may tighten monetary policy by increasing the nominal interest rate. Since the tax cut does not directly affect the market for loanable funds, the increase in the nominal interest rate would lead to a corresponding increase in the real interest rate. This increase in the real interest rate would discourage investment, leading to a fall in investment.

A Tax Cut Combined with Tight Money, as Was the Case