Question

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Consider the typical IS-LM set-up characterized by the following equations: IS : Y = C(Y - T) +I(Y. i) +G M LM: P =Y L(i) Suppose the economy is in a short run equilibrium. The government decides to perform contractionary fiscal policy by increasing taxes. (a) (5 points) Draw the effect this policy will have in the IS-LM framework (1 graph, Method 3). Label all axes, curves, the new and the old equilibrium.

Answer 1

interest M A B IS IS2 output / Incow. The contractionary fiscal policy will shift. IS curve from Is, to Ihr The equilibrium from point Ato B. that the. can 3 using the diagram in (as we say lefteward shift in Is come from Is, to Ise mine. 1) Reduce output from Y, to Y2 2) Declear interest rate from i to iz 3) The fall in output /income will lower the consumption 4) The fall in interest rate will lead to higher investment. interest . LM2 LM, A is iz IS, IS2 the LM & output/ Incon Y Y₂Y The contractionary monetary policy will shift curve upward from LM, to LM2 (in leftward d) The contractionary monetary policy will lead to 15 Lower output from Y2 to Y3. 2) But interest rate will move back to original level i. ( New eq. New eq. c).