Question

Assume that fiscal policy can be accomplished by changing only one of G and T. In the IS-LM framework, suppose the effect on the general equilibrium output is the same between expansionary fiscal policy and expansionary monetary policy. Which one would you expect to have a greater impact on the equilibrium consumption? Explain in words. Hint: Monetary policy affects also affects Y in the IS-LM framework!

Answer 1

Given both fiscal policy and monetary policy affects equilibrium output. Expansionary fiscal policy like decrease in the tax rate will have direct and immediate impact on the consumption component of aggregate demand. Decrease in the tax rate will increase disposable income(Income less tax). Thus consumers have more money at hand and will demand more goods and services. Thus consumption rises and thereby aggregate demand.

Expansionary monetary policy increases the supply of money in the economy and thus income of households. Increase in income leads to increase in the demand for goods and thus increase in the consumption. But increase in the money supply in the economy takes time. Thus fiscal policy like decreases in the tax rate lead to immediate increase in consumption.