Question

Assume you run the central bank of a small open economy with fixed exchange rates. Output, unemployment and inflation are where you want them to be. Now the fiscal authorities pass a massive tax cut. What policy, if any, should you follow to stabilize output?

Answer 1

Effect of tax cut: Expansionary fiscal policy is a type of policy which reduces tax and raise government spending. It will raise the disposable income of people which will induce them to spend more moeny of goods and services in an economy. It will shift the IS curve to its right from IS to IS1 while LM curve remains the same which shifts the rate of interest upward from i to i1 and raise level of output from Y to Y1.

Interest Rate Output y ,

To keep the output at stable level, I would adopt recessionary monetary policy which would reduce the supply of money in an economy and shifts the LM curve to its left from LM to LM1 while IS curve remains the same, which will raise the rate of interest further to i2 level while output level declines to its initial level. In total, economy will shift from point A to C.

output - -- - - - - --- Interest Rate --