Question

Prime minter Justin Trudeau is concerned about the economic impact of COVID-19 pandemic on already sluggish Canadian economy. Governments across the country are spending unprecedently to help Canadians to survive through the pandemic. But nearly $146 billion pandemic response government spending has resulted in the unprecedented budgetary deficit.

A. To help stimulate the economy, increasing government spending (expansionary fiscal policy) and increasing money supply (expansionary monetary policy) is proposed. Compare the effects of these two policies in terms of their implications for the current account in the framework of the IS and LM model. (2 points)

B. Now, suppose that Canadian firms do not increase investment due to the lower interest rate rather decide to reduce investment expenditure today in new factories and office space. How will this decrease in investment affect output, interest rates, and the current account? (1.5 points)

C. Now suppose the Canadian firms are very optimistic and very responsive to the interest rate – the firms will cancel most of their changes in investment plans if the interest rate falls. How will this affect your answer in part B? (1.5 points)

Answer 1

A. To stimulate the economy, Canada has declared a package of $146 billion which is an unexpected budgetary deficit. So at a time government had taken two expansionary policies together so fiscal policy and monetary policy. where government spending and tax reduction will work better on the economic growth

i) when there is a fiscal policy of government spending it will increase the demand and that will bring the output to its potential level at a high price. this high price is the representation of inflation prevailing in the market due to pandemic. In the given figure the initial equilibrium point is E1 whereas the output is Y1 and the price is P1. After an increase in government spending the equilibrium point been shifted to E1 with a new potential output Y2 and price P2.

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ii) In the case of monetary policy, the government has taken the measure of the purchase the bonds with tax reduction, which leads to a simultaneous increase in disposable income and current income. this activity will increase the flow of money in the market and that will push the interest rate down. in the given figure the initial equilibrium is E1 output is Y1 and the interest rate is i1 after implementation of monetary policy there is a change in equilibrium position to E2 and the potential.

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B. if the investors are not interested to invest any more due to a low-interest rate then there is a shift in equilibrium point to E3 and the output decrease to Y3 with the same i2 interest rate. her the impact on the current account is the deficit as the policy could not work as expectedly.

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C) when the investors are more optimistic and take this monetary policy as an opportunity then investors will invest more wich will shift the AD to Ad1 and the new equilibrium position can be derived as E3 which is similar to the initial one due to increase in the price of the product and that push the interest rate back to its original position i.e i1 with a new potential level of output Y3 and current account will be benefited out of it.

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