Question

Consider the typical IS-LM set-up characterized by the following equations: IS : Y = C(Y - T) +I(Y, i) +G LM : M 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. (b) (5 points) Using your graph from part (a), describe the equilibrium change in 4 variables listed below following an increase in taxes: Output: The interest rate: Consumption: Investment:

Answer 1

interest lat a) Ly. IS, • IS2 YY Bosno Incandel The contractionary fiscal policy will shift the IS curve leftward from Is, to Ise. The equilibrium will shift from point A to B. that the can say b) using the diagram in las due to lefterard shift in Is come from Is, to 152 contractionary fiscal policy will 1) Reduce autput from y, to Y. 2) Decrease interest rate from i, to iz. 3) The fall in output / Income will lower the consumption. higher inuestment 4) The fall in interest rate will lead to interest late (M2. LMI ii 2 I non. The 'Is Isi output) Y3 Y2Y. contractionary monetary policy will shift LM curve upward from LM, to LM2 (in leftwand direction] d) This will lead to further sto fall in output to and increas in interest rate i, * Therefore contractionary monetary policy will lower output further, But will increase interest rate, back to original leue ii