Question

Monetary policy and fiscal policy often change at the same time. 

(a) Suppose the government wants to raise investment but keep output constant. In the IS-LM model, what mix of monetary and fiscal policy will achieve this goal? In other words, what needs to happen to M and G or T? Sketch the IS-LM model and illustrate your answer graphically. 

(b) In the early 1980s, the U.S. government cut taxes and ran a budget deficit while the Fed pursued a tight monetary policy and decreased the money supply. What effect would this policy mix have on the equilibrium interest rate and output? Sketch the IS-LM model and illustrate your answer graphically.

Answer 1

In following graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0.

(a)

Increase in investment (by using expansionary fiscal policy by increasing G or decreasing T) will shift IS curve right, increasing interest rate and increasing output. To keep output unchanged, contractionary monetary policy should be used by lowering money supply (M), which will shift LM curve leftward, further increasing interest rate but restoring output to original level.

In following graph, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1. Decrease in M shifts LM curve left to LM1, intersecting IS0 at point C at further higher interest rate r2 but restoring output to Y0.

(b)

Lower tax will shift IS curve right, increasing interest rate and increasing output. Decreased money supply (M) will shift LM curve leftward, further increasing interest rate and decreasing output.

In following graph, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r1 and higher output Y1. Decrease in money supply shifts LM curve left to LM1, intersecting IS0 at point C at further higher interest rate r2, and since rightward shift in IS curve is equal in magnitude to the leftward shift in LM curve (this is by drawing only and need not necessarily be true), output is unchanged at Y0.